LECTURE NOTE OF CHAPTER 6 – FINANCIAL MANAGEMENT COURSE

CHAPTER 6: CAPITAL BUDGETING

I. CAPITAL BUDGETING AND ESTIMATING CASH FLOWS
1. Capital budgeting:
Capital budgeting is the process of planning for purchases of assets whose returns are
expected to continue beyond one year. Capital budgeting involves

• Generating investment project proposals consistent with the firm’s strategic objectives
• Estimating after-tax incremental operating cash flows for investment projects
• Evaluating project incremental cash flows
• Selecting projects based on a value-maximizing acceptance criterion
• Reevaluating implemented investment projects continually and performing postaudits for
completed projects
The capital budgeting process is concerned primarily with the estimation of the cash
flows associated with a project, not just the project’s contribution to accounting profits.
Because cash, not accounting income, is central to all decisions of the firm, we express whatever
benefits we expect from a project in terms of cash flows rather than income flows.
Typically, a capital expenditure requires an initial cash outflow, termed the net
investment. It is important to measure a project’s performance in terms of the net (operating)
cash flows it is expected to generate over a number of future years.

2. Concepts of cash flows ‘s estimation:

2.1 Cash Flow versus Accounting Income :
There is a difference between cash flows and accounting income. We also saw that cash
is what people and firms spend or reinvest; so the present value of cash flows, not accounting
income, is the basis of a firm’s value. That’s why, we discounted net cash flows, not net income,
to find projects’ NPVs.
Many things can lead to differences between net cash flows and net income.

- Depreciation is not a cash outlay, but it is deducted when net income is calculated.
- If a project requires an addition to working capital, this directly affects cash flows but not
net income.
Important thing to keep in mind is this: For capital budgeting purposes, the project’s cash
flows, not its accounting income.

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2.2 Basic principles of cash flow estimation:

Regardless of whether a project’s cash flows are expected to be normal or nonnormal,
certain basic principles should be applied during their estimation, including the following:
• Cash flows should be measured on an incremental basis: the information must be
presented on an incremental basis, so that we analyze only the difference between the
cash flows of the firm with and without the project
• Cash flows should be measured on an after-tax basis. Because the initial investment
made on a project requires the outlay of after-tax cash dollars, the returns from the project
should be measured in the same units, namely, after-tax cash flows.
• All the indirect effects of a project should be included in the cash flow calculations.
if a proposed plant expansion requires that working capital be increased for the firm as a
whole , the increase in working capital should be included in the net investment required
for the project. Other indirect effects may occur when one division of a firm introduces a
new product that competes directly with a product produced by another division. The first
division may consider this product desirable, but when the impact on the second
division’s sales is considered, the project may be much less attractive.
• Sunk costs should not be considered when evaluating a project. A sunk cost is
unrecoverable past outlays that, as they cannot be recovered, should not affect present
actions or future decisions. Because sunk costs cannot be recovered, they should not be
considered in the decision to accept or reject a project.
• The value of resources used in a project should be measured in terms of their
opportunity costs. Opportunity costs is what is lost by not taking the next-best
investment alternative. If we have allocated plant space to a project and this space can be
used for something else, its opportunity cost must be included in the project’s evaluation
• In estimating cash flows, anticipated inflation must be taken into account. Often
there is a tendency to assume erroneously that price levels will remain unchanged
throughout the life of a project. If the required rate of return for a project to be accepted
embodies a premium for inflation (as it usually does), then estimated cash flows must
also reflect inflation. Such cash flows are affected in several ways. If cash inflows
ultimately arise from the sale of a product, expected future prices affect these inflows. As
for cash outflows, inflation affects both expected future wages and material costs.

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3. How to calculate incremental cash flows:

There are three steps to estimate the project’s cash flow:
Step 1: Initial cash outflow (the initial net cash investment)
Step 2: Interim incremental net cash flows: those net cash flows occurring after the initial
cash investment but not including the final period’s cash flow
Step 3: Terminal-year incremental net cash flow (the final period’s net cash flow). This
period’s cash flow is singled out for special attention because a particular set of cash flows
often occurs at project termination.
Step 1: Initial cash outflow - the initial net cash investment
The Initial cash outflow in a project is defined as the project’s initial net cash outlay, that
is, the outlay at time (period) 0. It is calculated using the following steps:
Expansion Replacement
project projects
The new project cost plus any installation X X
and shipping costs associated with
acquiring the asset and putting it into service
+ Any increases in net working capital initially X X
required as a result of the new
Investment
- The net proceeds from the sale of existing X
assets when the investment is a replacement
decision
+/- The taxes associated with the sale of the X
existing assets and/or the purchase of
the new assets
= Initial cash outflow
Step 2: Estimate the incremental net cash flows
Capital budgeting is concerned primarily with the after-tax net (operating) cash flows
(NCF) of a particular project. Other word, NCF is the change in cash inflows minus change in
cash outflows. For any year during the life of a project, NCF is calculated by:
NCF = OEAT + Dep – NWC = OCF - NWC
Where: OEAT: the change in operating earnings after taxes
Dep:the change in depreciation
NWC : the change in the net working capital investment required by the firm to support
the project
OCF: the change in operating cash flow
Expansion Replacement
project projects
The change in net sale X X
- The change in operating costs X X
- The change in depreciation X X
- The change in tax X X
= The change in operating earning X X
after tax (OEAT)

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+ The change in depreciation X X

(Dep)
= The change in Operating cash X X
flow (OCF)
- The change in net working capital X X
(NWC)
= Net operating cash flow (NCF)
Note of caculation’s the change in operating cash flow
1. Calculate the net change in after –tax operating cash flow start from opearting earning
after tax plus depreciation
2. Interest charged is not included in calculation OCF
Step 3: Estimate the cash flow at the last year of projects:
At the ending time, we recover the after-tax salvage value and net working captital.
Expansion Replacement
project projects
Gain or loss from sale of new assets X X
+/- Gain or loss of sale of existing assets X
+ The change in net working capital X X
(NWC)
= Net cash flow at the ending time of
project
Recovery after-tax salvage value:
After- tax salvage value = MV – (MV – BV)*t
Where: MV: the market value of assets
BV: the book value of assets
t: the tax rate
If MV = BV -> the salvage value is equal the market value of assets
If MV > BV -> the gain from sale of assets and this gain will be deducted by tax
If MV < BV -> the loss from sale of assets and this loss will be compensated by tax
Recorvery net working capital:
At the end of a project’s life, all net working capital additions required over he project’s
life are recovered—not just the initial net working capital outlay occurring at time 0. Hence, the
total accumulated net working capital is normally recovered in the last year of the project. This
decrease in net working capital in the last year of the project increases the net cash flow for that
year, all other things being equal. Of course, no tax consequences are associated with the
recovery of NWC.
4. Case studies: Example of Asset Expansion
The Amprham company intends to invest the new machine that produces 15,000 products
each year. Each products costs $2. The company plans that the new machine will be manufacture
in 4 years ( 20x4 – 20x8). The machine is sold at $9500 and the transporatation fee is charged at
500. The machine will be depreciated in 5 years with the depreciation proportion in 4 years at
20%, 32%, 19% and 12%. In the last year (20x8), the machine will be sold at the price of $2000
and the book value of machine will be $1700. The company has to invest $2000 in net working
captial. The variable cost is accouted of 60% revenue. The fix operating cost is $5000 each year
(exclude the depreciation) and the tax rate is 40%.

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Assume that the project start at the end of 20x4 and the cash flow appears at the end of
each year.Calculate the net cash flow of this projects?

DEPRECIATION
20x5 20x6 20x7 20x8
Deprecition proportion 0.2 0.32 0.19 0.12
Depreciation = the cost of machine * Deprecitaion
proportion 2000 3200 1900 1200
Book value 8000 4800 2900 1700
Salvage value 1880

ANALYSIS OF AN EXPANSION PROJECT

20x4 20x5 20x6 20x7 20x8
I.INITIAL NET INVESTMENT
Cost of new machine -9500
Transportation fee -500
Net working captial -2000
Net investment -12000
II. OPERATING CASH FLOW
Revenue 30000 30000 30000 30000
Variable cost 18000 18000 18000 18000
Fix cost 5000 5000 5000 5000
Depreciation 2000 3200 1900 1200
Income before tax 5000 3800 5100 5800
Tax 2000 1520 2040 2320
OEAT 3000 2280 3060 3480
OCF 5000 5480 4960 4680
III. CASH FLOW AT THE END OF PROJECT
Salvage value 1880
Net working capital 2000
Cash flow at the end of project 3880
NET CASH FLOW -12000 5000 5480 4960 8560

II. CAPITAL BUDGETING TECHNIQUES

In this section, we evaluate four alternative methods of project evaluation and selection
used in capital budgeting:
1. Payback period
2. Internal rate of return (IRR)
3. Net present value (NPV)
4. Profitability index (PI)
The kinds of projects:
Classification due to the relationship of projects:
• Independent Projects is one whose acceptance or rejection does not directly eliminate
other projects from consideration. A project whose

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• Mutually Exclusive Projects is one whose acceptance precludes the acceptance of one
or more alternative proposals. Because two mutually exclusive projects have the capacity
to perform the same function for a firm, only one should be chosen.
Classification due to the purpose of investment:
• Expansion projects
• Replacement projects
1. Payback (PB) period:
The payback period (PBP) of an investment project tells us the number of years
required to recover our initial cash investment based on the project’s expected cash flows
Decision Rule
Paypack period < specified maximum period: accept
Payback period > specified maximum period: reject
However, the payback method has a number of serious shortcomings, and it should not be
used in deciding whether to accept or reject an investment project.
- Payback method gives equal weight to all cash inflows within the payback period,
regardless of when they occur during the period. In other words, the technique ignores the
time value of money
- Payback provides no objective criterion for decision making that is consistent with
shareholder wealth maximization. The payback methods (both discounted and
undiscounted) may reject projects with positive net present values.
- The payback method is sometimes justified on the basis that it provides a measure of the
risk associated with a project. Although it is true that less risk may be associated with a
shorter payback period than with a longer one, risk is best thought of in terms of the
variability of project returns.
In summary, payback is not a satisfactory criterion for investment decision making
because it may lead to a selection of projects that do not make the largest possible contribution to
a firm’s value.
2. Net present value (NPV):
The net present value (NPV) of an investment proposal is the present value of the
proposal’s net cash flows less the proposal’s initial cash outflow. The net present value method is
also sometimes called the discounted cash flow (DCF) technique.

Where k is the required rate of return and all the other variables remain as previously defined
NPV is the net present value
CF is the net cash flow
ICO: the initial cash outflow
The cash flows are discounted at the firm’s required rate of return; that is, its cost of
capital. A firm’s cost of capital is defined as its minimum acceptable rate of return for projects of
average risk.
Decision Rule:
+ NPV > 0 ; accept project
+ NPV < 0 : reject project
Independent Projects: choose the project with NPV > 0
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Mutually Exclusive Projects: Choose project NPV is highest and greater than 0
The net present value criterion has a weakness in that many people find it difficult to
work with a present value dollar return rather than a percentage return. As a result, many firms
use another present value–based method that is interpreted more easily: the internal rate of return
method
3. Internal Rate of Return:
The internal rate of return (IRR) for an investment proposal is the discount rate that
equates the present value of the expected net cash flows (CFs) with the initial cash outflow
(ICO).

Decision Rule:
IRR >= cost of capital : accept project
IRR < cost of capital: reject project
Independent Projects: Choose the project with IRR> cost of capital. The net present value and
internal rate of return techniques result in the same accept – reject decision.
Mutually Exclusive Projects: choose the project having the highest internal rate of return as
long as IRR >= cost of capital.

However if two projects are mutually exclusive projects, the NPV and IRR conflicts

However, some potential problems are involved in using the internal rate of return
technique. The problem is multiple internal rates of return
Whenever a project has multiple internal rates of return, the pattern of cash flows over
the project’s life contains more than one sign change, for example, – ↑ + + ↑ –. In this case,
there are two sign changes (indicated by the arrows)—from minus to plus and again from plus to
minus.

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4. Profitability index (PI)

The profitability index (PI), or benefit-cost ratio, of a project is the ratio of the present
value of future net cash flows to the initial cash outflow. It can be expressed as

The profitability index is interpreted as the present value return for each dollar of initial
investment
Decision Rule
+ PI > 1 : accept project
+ PI < 1 : reject project
Independent Projects: choose project having PI > 1
Mutually Exclusive Projects: choose project having PI is highest and greater than 1
Similar to IRR method, if projects are mutually exclusive projects, PI and NPV give conflicts.

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