- Cash Flows and Other Topics in

Capital Budgeting

 2005, Pearson Prentice Hall

Capital Budgeting: The process of planning
for purchases of long-term assets.

For example: Our firm must decide whether

to purchase a new plastic molding machine
for $127,000. How do we decide?
 Will the machine be profitable?
 Will our firm earn a high rate of return on
the investment?
 The relevant project information follows:
 The cost of the new machine is $127,000.
 Installation will cost $20,000.
 $4,000 in net working capital will be needed at
the time of installation.
 The project will increase revenues by $85,000 per
year, but operating costs will increase by 35% of
the revenue increase.
 Simplified straight line depreciation is used.
 Class life is 5 years, and the firm is planning to
keep the project for 5 years.
 Salvage value at the end of year 5 will be $50,000.
 14% cost of capital; 34% marginal tax rate.
 Capital Budgeting Steps
1) Evaluate Cash Flows
Look at all incremental cash flows
occurring as a result of the project.
 Initial outlay
 Differential Cash Flows over the life
of the project (also referred to as
annual cash flows).
 Terminal Cash Flows
 Capital Budgeting Steps
1) Evaluate Cash Flows

Initial Terminal
outlay Cash flow

0 1 2 3 4 5 6 ... n

Annual Cash Flows

 Capital Budgeting Steps

2) Evaluate the Risk of the Project

 We’ll get to this in the next chapter.
 For now, we’ll assume that the risk of the
project is the same as the risk of the
overall firm.
 If we do this, we can use the firm’s cost of
capital as the discount rate for capital
investment projects.
 Capital Budgeting Steps

3) Accept or Reject the Project

 Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
“time 0?”

(Purchase price of the asset)

+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
 Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
“time 0?”

(127,000)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
 Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
“time 0?”

(127,000)
+ ( 20,000)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
 Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
“time 0?”

(127,000)
+ ( 20,000)
(147,000)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
 Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
“time 0?”

(127,000)
+ (20,000)
(147,000)
+ (4,000)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
 Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
“time 0?”

(127,000)
+ (20,000)
(147,000)
+ (4,000)
+ 0
Net Initial Outlay
 Step 1: Evaluate Cash Flows
 a) Initial Outlay: What is the cash flow at
“time 0?”

(127,000) Purchase price of asset

+ (20,000) Shipping and installation
(147,000) Depreciable asset
+ (4,000) Net working capital
+ 0 Proceeds from sale of old asset
($151,000) Net initial outlay
 Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
“time 0?”

(127,000) Purchase price of asset

+ (20,000) Shipping and installation
(147,000) Depreciable asset
+ (4,000) Net working capital
+ 0 Proceeds from sale of old asset
($151,000) Net initial outlay
 Step 1: Evaluate Cash Flows
b) Annual Cash Flows: What
incremental cash flows occur over the
life of the project?
 For Each Year, Calculate:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
 For Years 1 - 5:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
 For Years 1 - 5:
85,000
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
 For Years 1 - 5:
85,000
(29,750)
- Depreciation on project

Incremental earnings before taxes

- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
 For Years 1 - 5:
85,000
(29,750)
(29,400)
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
 For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
 For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
 For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
+ Depreciation reversal
Annual Cash Flow
 For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
29,400
Annual Cash Flow
 For Years 1 - 5:
85,000 Revenue
(29,750) Costs
(29,400) Depreciation
25,850 EBT
(8,789) Taxes
17,061 EAT
29,400 Depreciation reversal
46,461 = Annual Cash Flow
 Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash

flow at the end of the project’s life?

Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow
 Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash

flow at the end of the project’s life?

50,000 Salvage value

+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow
 Tax Effects of Sale of Asset:
 Salvage value = $50,000.
 Book value = depreciable asset - total
amount depreciated.
 Book value = $147,000 - $147,000
= $0.
 Capital gain = SV - BV
= 50,000 - 0 = $50,000.
 Tax payment = 50,000 x .34 = ($17,000).
 Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash

flow at the end of the project’s life?

50,000 Salvage value

(17,000) Tax on capital gain
Recapture of NWC
Terminal Cash Flow
 Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash

flow at the end of the project’s life?

50,000 Salvage value

(17,000) Tax on capital gain
4,000 Recapture of NWC
Terminal Cash Flow
 Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash

flow at the end of the project’s life?

50,000 Salvage value

(17,000) Tax on capital gain
4,000 Recapture of NWC
37,000 Terminal Cash Flow
 Project NPV:

 CF(0) = -151,000.
 CF(1 - 4) = 46,461.
 CF(5) = 46,461 + 37,000 = 83,461.
 Discount rate = 14%.
 NPV = $27,721.
 We would accept the project.
 Capital Rationing

 You could rank the projects by IRR:

IRR
25% Our budget is limited
so we accept only
20% projects 1, 2, and 3.
15%
10%
5% 1 2 3 4 5

$X $
 Capital Rationing

 You could rank the projects by IRR:

IRR
25% Our budget is limited
so we accept only
20% projects 1, 2, and 3.
15%
10%
5% 1 2 3

$X $
 Capital Rationing

 Ranking projects by IRR is not

always the best way to deal with a
limited capital budget.
 It’s better to pick the largest NPVs.
 Let’s try ranking projects by NPV.
Problems with Project Ranking

1) Mutually exclusive projects of unequal

size (the size disparity problem)
 The NPV decision may not agree with
IRR or PI.
 Solution: select the project with the
largest NPV.
 Size Disparity Example
Project A
year cash flow
0 (135,000)
1 60,000
2 60,000
3 60,000
required return = 12%
IRR = 15.89%
NPV = $9,110
PI = 1.07
 Size Disparity Example
Project A Project B
year cash flow year cash flow
0 (135,000) 0 (30,000)
1 60,000 1 15,000
2 60,000 2 15,000
3 60,000 3 15,000
required return = 12% required return = 12%
IRR = 15.89% IRR = 23.38%
NPV = $9,110 NPV = $6,027
PI = 1.07 PI = 1.20
 Size Disparity Example
Project A Project B
year cash flow year cash flow
0 (135,000) 0 (30,000)
1 60,000 1 15,000
2 60,000 2 15,000
3 60,000 3 15,000
required return = 12% required return = 12%
IRR = 15.89% IRR = 23.38%
NPV = $9,110 NPV = $6,027
PI = 1.07 PI = 1.20
 Problems with Project Ranking
2) The time disparity problem with mutually
exclusive projects.
 NPV and PI assume cash flows are
reinvested at the required rate of return for
the project.
 IRR assumes cash flows are reinvested at
the IRR.
 The NPV or PI decision may not agree with
the IRR.
 Solution: select the largest NPV.
 Time Disparity Example
Project A
year cash flow
0 (48,000)
1 1,200
2 2,400
3 39,000
4 42,000
required return = 12%
IRR = 18.10%
NPV = $9,436
PI = 1.20
 Time Disparity Example
Project A Project B
year cash flow year cash flow
0 (48,000) 0 (46,500)
1 1,200 1 36,500
2 2,400 2 24,000
3 39,000 3 2,400
4 42,000 4 2,400
required return = 12% required return = 12%
IRR = 18.10% IRR = 25.51%
NPV = $9,436 NPV = $8,455
PI = 1.20 PI = 1.18
 Time Disparity Example
Project A Project B
year cash flow year cash flow
0 (48,000) 0 (46,500)
1 1,200 1 36,500
2 2,400 2 24,000
3 39,000 3 2,400
4 42,000 4 2,400
required return = 12% required return = 12%
IRR = 18.10% IRR = 25.51%
NPV = $9,436 NPV = $8,455
PI = 1.20 PI = 1.18
 Mutually Exclusive Investments
with Unequal Lives

 Suppose our firm is planning to expand

and we have to select one of two machines.
 They differ in terms of economic life and
capacity.
 How do we decide which machine to select?
The after-tax cash flows are:
Year Machine 1 Machine 2
0 (45,000) (45,000)
1 20,000 12,000
2 20,000 12,000
3 20,000 12,000
4 12,000
5 12,000
6 12,000
Assume a required return of 14%.
 Step 1: Calculate NPV
 NPV1 = $1,433
 NPV2 = $1,664

 So, does this mean #2 is better?

 No! The two NPVs can’t be
compared!
 Step 2: Equivalent Annual
Annuity (EAA) method

 If we assume that each project will be

replaced an infinite number of times in the
future, we can convert each NPV to an
annuity.
 The projects’ EAAs can be compared to
determine which is the best project!
 EAA: Simply annuitize the NPV over the
project’s life.
 EAA with your calculator:

 Simply “spread the NPV over the life

of the project”

 Machine 1: PV = 1433, N = 3, I = 14,

solve: PMT = -617.24.

 Machine 2: PV = 1664, N = 6, I = 14,

solve: PMT = -427.91.
 EAA1 = $617
 EAA2 = $428
 This tells us that:
 NPV1 = annuity of $617 per year.
 NPV2 = annuity of $428 per year.
 So, we’ve reduced a problem with
different time horizons to a couple of
annuities.
 Decision Rule: Select the highest EAA.
We would choose machine #1.
Step 3: Convert back to NPV

 Step 3: Convert back to NPV

 Assuming infinite replacement, the
EAAs are actually perpetuities. Get the
PV by dividing the EAA by the required
rate of return.
 Step 3: Convert back to NPV

 Assuming infinite replacement, the
EAAs are actually perpetuities. Get the
PV by dividing the EAA by the required
rate of return.

 NPV 1 = 617/.14 = $4,407

 Step 3: Convert back to NPV

 Assuming infinite replacement, the
EAAs are actually perpetuities. Get the
PV by dividing the EAA by the required
rate of return.

 NPV 1 = 617/.14 = $4,407

 NPV 2 = 428/.14 = $3,057
 Step 3: Convert back to NPV

 Assuming infinite replacement, the EAAs
are actually perpetuities. Get the PV by
dividing the EAA by the required rate of
return.

 NPV1 = 617/.14 = $4,407

 NPV 2 = 428/.14 = $3,057

 This doesn’t change the answer, of course;
it just converts EAA to an NPV that can be
compared.
 Practice Problems:
Cash Flows & Other Topics
in Capital Budgeting
Project Information: Problem 1a
 Cost of equipment = $400,000.
 Shipping & installation will be $20,000.
 $25,000 in net working capital required at setup.
 3-year project life, 5-year class life.
 Simplified straight line depreciation.
 Revenues will increase by $220,000 per year.
 Defects costs will fall by $10,000 per year.
 Operating costs will rise by $30,000 per year.
 Salvage value after year 3 is $200,000.
 Cost of capital = 12%, marginal tax rate = 34%.
 Problem 1a
Initial Outlay:

(400,000) Cost of asset

+ ( 20,000) Shipping & installation
(420,000) Depreciable asset
+ ( 25,000) Investment in NWC
($445,000) Net Initial Outlay
For Years 1 - 3: Problem 1a
220,000 Increased revenue
10,000 Decreased defects
(30,000) Increased operating costs
(84,000) Increased depreciation
116,000 EBT
(39,440) Taxes (34%)
76,560 EAT
84,000 Depreciation reversal
160,560 = Annual Cash Flow
 Problem 1a
Terminal Cash Flow:

Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow
 Problem 1a
Terminal Cash Flow:

 Salvage value = $200,000.

 Book value = depreciable asset - total
amount depreciated.
 Book value = $168,000.
 Capital gain = SV - BV = $32,000.
 Tax payment = 32,000 x .34 = ($10,880).
 Problem 1a

Terminal Cash Flow:

200,000 Salvage value

(10,880) Tax on capital gain
25,000 Recapture of NWC
214,120 Terminal Cash Flow
 Problem 1a

 Find the NPV and IRR