Capital Budgeting and

Estimating Cash Flows

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 What is Capital Budgeting?

The process of identifying,

analyzing, and selecting
investment projects whose
returns (cash flows) are
expected to extend beyond
one year.

2
 The Capital
Budgeting Process
▪ Generate investment proposals
consistent with the firm’s strategic
objectives.
▪ Estimate after-tax incremental
operating cash flows for the
investment projects.
▪ Evaluate project incremental cash
flows.
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 The Capital
Budgeting Process

▪ Select projects based on a

value-maximizing acceptance
criterion.
▪ Reevaluate implemented investment
projects continually and perform
postaudits for completed projects.

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 Classification of Investment
Project Proposals

1. New products or expansion of existing

products
2. Replacement of existing equipment or
buildings
3. Research and development
4. Exploration
5. Other (e.g., safety or pollution related)
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 Screening Proposals
and Decision Making
1. Section Chiefs
2. Plant Managers Advancement
to the next
3. VP for Operations level depends
4. Capital Expenditures on cost
Committee and strategic
5. President importance.
6. Board of Directors
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 Estimating After-Tax
Incremental Cash Flows
Basic characteristics of relevant
project flows
Cash (not accounting income) flows
Operating (not financing) flows
After-tax flows
Incremental flows
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 Estimating After-Tax
Incremental Cash Flows
Principles that must be adhered to
in the estimation
Ignore sunk costs
Include opportunity costs
Include project-driven changes in
working capital net of spontaneous
changes in current liabilities
Include effects of inflation
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 Tax Considerations
and Depreciation
▪ Depreciation represents the systematic
allocation of the cost of a capital asset
over a period of time for financial
reporting purposes, tax purposes, or
both.
▪ Generally, profitable firms prefer to use
an accelerated method for tax reporting
purposes.

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 Depreciable Basis
In tax accounting, the fully installed
cost of an asset. This is the amount
that, by law, may be written off over
time for tax purposes.
Depreciable Basis =
Cost of Asset + Capitalized
Expenditures
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 Capitalized Expenditures

Capitalized Expenditures are

expenditures that may provide benefits
into the future and therefore are treated
as capital outlays and not as expenses of
the period in which they were incurred.
Examples: Shipping and installation

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 Sale or Disposal of a
Depreciable Asset
▪ Generally, the sale of a “capital asset” (as
defined by the IT Dept) generates a
capital gain (asset sells for more than
book value) or capital loss (asset sells for
less than book value).
▪ Often historically, capital gains
income has received more favorable
tax treatment than operating income.
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 Corporate Capital Gains /
Losses

▪ Currently, capital gains are taxed at

20%, if indexed value is used for
corporations, or 10% on historical
cost.
▪ Capital losses are deductible only
against capital gains.

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 Calculating the Incremental
Cash Flows
▪ Initial cash outflow -- the initial net cash
investment.
▪ Interim incremental net cash flows --
those net cash flows occurring after the
initial cash investment but not including
the final period’s cash flow.
▪ Terminal-year incremental net cash flows
-- the final period’s net cash flow.
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 Initial Cash Outflow
a) Cost of “new” assets
b) + Capitalized expenditures
c) + (-) Increased (decreased) NWC
d) - 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
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 Incremental Cash Flows
a) Net incr. (decr.) in operating revenue
less (plus) any net incr. (decr.) in
operating expenses, excluding depr.
b) - (+) Net incr. (decr.) in tax depreciation
c) = Net change in income before taxes
d) - (+) Net incr. (decr.) in taxes
e) = Net change in income after taxes
f) + (-) Net incr. (decr.) in tax depr. charges
g) = Incremental net cash flow for period
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 Terminal-Year Incremental
Cash Flows
a) Calculate the incremental net cash
flow for the terminal period
b) + (-) Salvage value (disposal/reclamation
costs) of any sold or disposed assets
c) - (+) Taxes (tax savings) due to asset sale
or disposal of “new” assets
d) + (-) Decreased (increased) level of “net”
working capital
e) = Terminal year incremental net cash flow
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 Example of an Asset
Expansion Project
XL Dhaba is considering the purchase of a new
juice extracting machine. The machine will cost
110,000 plus 10000 for shipping and installation.
NWC will rise by 15,000. Company forecasts that
revenues will increase by 110,000 for each of the
next 4 years and will then be sold (scrapped) for
10,000 at the end of the fourth year, when the life of
the machine ends. Operating costs will rise by
70,000 for each of the next four years. XL Dhaba is
in the 30% tax bracket.
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 Initial Cash flow
a) - 110,000
b) - 10,000
c) - 15,000
d) + 0 (not a replacement)
e) - (+) 0 (not a replacement)
f) = -135,000

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 Depreciation Calculation

Initial Investment- Salvage Value

Depreciation= -------------------------------------------------
Economic Life
110000-10000
= ------------------------------ = 25000
4

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 Incremental Cash Flows
Year 1 Year 2 Year 3 Year 4
a) 40,000 40,000 40,000 40,000
b) - 25,000 25,000 25,000 25,000
c) = 15,000 15,000 15,000 15,000
d) - 4,500 4,500 4,500 4,500
e) = 11,500 11,500 11,500 11,500
f) + 25,000 25,000 25,000 25,000
g) = 36,500 36,500 36,500 36,500

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 Terminal-Year Incremental
Cash Flows
a) 36,500 The incremental cash flow
from the previous slide in Year
4.
b) + 10,000 Salvage Value.
c) - 0
d) + 15,000 NWC - Project ends.
e) = 51,500 Terminal-year incremental
cash flow.

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 Summary of Project Net
Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
-135,000 36,500 36,500 36,500 51,500

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 Example of an Asset
Replacement Project
Let us assume that previous asset expansion project is
actually an asset replacement project. The original
basis of the machine was 50,000 and depreciated using
straight-line over five years (10,000 per year). The
machine has three years of depreciation and four years
of useful life remaining. XL Dhaba can sell the current
machine for 15,000. The new machine will not increase
revenues (remain at 110,000) but it decreases operating
expenses by 10,000 per year (old = 80,000). NWC will
rise to 20,000 from 5,000 (old).
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 Initial Cash Outflow
a) 110,000
b) + 10,000
c) + 15,000
d) - 15,000 (sale of “old” asset)
e) - 4,500 <---- (tax savings from
f) = 115,500 loss on sale of
“old” asset)

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 Calculation of the Change
in Depreciation
Year 1 Year 2 Year 3 Year 4
a) 25,000 25,000 25,000 25,000
b) - 10,000 10,000 10000 0 0
c) = 15,000 15,000 15,000 25,000
a) Represent the depreciation on the “new”
project.
b) Represent the remaining depreciation on the
“old” project.
c) Net change in tax depreciation charges.
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 Incremental Cash Flows
Year 1 Year 2 Year 3 Year 4
a) 10,000 10,000 10,000 10,000
b) - 15,000 15,000 15,000 25,000
c) = -5,000 -5000 -5000 -15,000
d) - -1,500 -1,500 -1,500 4,500
e) = -3,500 -3,500 -3,500 -11,500
f) + 15,000 15,000 15,000 25,000
g) = 11,500 11,500 11,500 13,500

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 Terminal-Year Incremental
Cash Flows
a) 13,500 The incremental cash flow
from the previous slide in Year
4.
b) + 10,000 Salvage Value.
c) - 0
d) + 15,000 Return of “added” NWC.
e) = 38,500 Terminal-year incremental
cash flow.

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 Summary of Project Net
Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
-135,000 36,500 36,500 36,500 51,500

Asset Replacement
Year 0 Year 1 Year 2 Year 3 Year 4
-115,500 11,500 11,500 11,500 38,500

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 Problem: 1(Purchase of a
New Asset)
Saraf Finial Fabricating Woks is considering automating its existing
finial casting and assembly department. The plant manager has
accumulated the following information for you:
•The automation proposal would result in reduced labour costs of Rs.
1500000 per year.
•The cost of defects is expected to remain at Rs. 50000 even if the
automation proposal is accepted.
•New equipment costing Rs. 5000000 would need to be purchased. For tax
purposes, the equipment will be depreciated on a straight-line basis over
its useful four-year life. The estimated final salvage value of the new
equipment is Rs. 500000.
•Annual maintenance costs will increase from Rs. 20000 to Rs. 80000 if
the new equipment is purchased.
•The company is subject to marginal tax rate of 30 per cent.
What are the relevant incremental cash inflows over the proposal’s useful
30 life and what is the incremental cash outflow at time 0?
 Problem: 2(Replacement
of an Old Asset)
Saha and Associates is considering the replacement of two machines that
are three years old with a new, more efficient machine. The old machines
could be sold currently for a total of Rs. 70000 in the secondary market,
but they would have zero salvage value if held to the end of their
remaining useful life. Their original depreciable basis totaled Rs. 300000.
They have a depreciated tax book value of 86400, and a remaining useful
life of eight years. The new machine can be purchased and installed for
Rs. 480000. It has a useful life of eight years, at the end of which a
salvage value of 40000 is expected. Due to greater efficiency, the new
machine is expected to result in incremental annual operating savings of
Rs. 100000. The company’s corporate tax rate is 40 percent, and is a loss
occurs in any year on the project, it is assumed that the company can
offset the loss against other company income. What are the incremental
cash inflows over the eight years, and what is the incremental cash
outflow at time 0?
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