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XMAFIN2 CAPITAL BUDGETING, CASH FLOWS

Capital budgeting is the process used to evaluate and select long-term investments consistent with the goal of owner wealth maximization. Capital expenditures are outlays made by the firm that are expected to produce benefits over the long term (a period greater than one year). Not all capital expenditures are made for fixed assets. An expenditure made for an advertising campaign may have long-term benefits. The primary motives for making capital expenditures include: Expansionincreasing the productive capacity of the firm, usually through the acquisition of fixed assets. Replacementreplacing existing assets with new or more advanced assets that provide the same function. Renewalrebuilding or overhauling existing assets to improve efficiency. Other motives include expenditures for nontangible projects that improve a firms profitability, such as advertising, research and development, and product development. A firm may also be required by law to undertake pollution control and similar projects. Expansion and replacement involve the purchase of new assets as compared with renewal, where old assets are upgraded. a. b. Proposal generation is the origination of proposed capital projects for the firm by individuals at various levels of the organization. Review and analysis is the formal process of assessing the appropriateness and economic viability of the project in light of the firms overall objectives. This is done by estimating cash flows arising from the project and evaluating them through capital budgeting techniques. Risk factors are also incorporated into the analysis phase. Decision making is the step where the proposal is compared against predetermined criteria and either accepted or rejected. Implementation of the project begins after the project has been accepted and funding is made available. Follow-up is the post-implementation audit of expected and actual costs and revenues generated from the project to determine if the return on the proposal meets pre-implementation projections.

c. d. e.

Basic Terminology a. Independent projects have cash flows unrelated to or independent of each other. Mutually exclusive projects have the same function as the other projects being considered. Therefore, they compete with one another; accepting one eliminates the others from further consideration. b. Firms under capital rationing have only a fixed amount of dollars available for the capital budget, whereas a firm with unlimited funds may accept all projects with a specified rate of return. c. The accept-reject approach evaluates capital expenditures using a predetermined minimum acceptance criterion. If the project meets the criterion, its accepted and vice versa. With ranking, projects are ranked from best to worst based on some predetermined measure, such as rate of return. d. A conventional cash flow pattern consists of an initial outflow followed by a series of inflows. A nonconventional cash flow pattern is any pattern in which an initial outlay is not followed by a series of inflows.

Capital budgeting projects should be evaluated using incremental after-tax cash flows, since after-tax cash flows are what is available to the firm. When evaluating a project, concern is placed only on added cash flows expected to result from its implementation. Expansion decisions can be treated as replacement decisions in which all cash flows from the old assets are zero. Both expansion and replacement decisions involve purchasing new assets. Replacement decisions are more complex because incremental cash flows resulting from the replacement must be determined. The three components of cash flow for any project are (1) initial investment, (2) operating cash flows, and (3) terminal cash flows. Sunk costs are costs that have already been incurred and thus the money has already been spent. Opportunity costs are cash flows that could be realized from the next best alternative use of an owned asset. Sunk costs are not relevant to the investment decision because they are not incremental. These costs will not change no matter what the final accept/reject decision (recall the IPhone @ Plan 1,799 illustration). Opportunity costs are a relevant cost. These cash flows could be realized if the decision is made not to change the current asset structure but to utilize the owned asset for this alternative purpose.

EXERCISE: ( sheet of yellow paper, 5 minutes)


An international company has spent Php4.5 billion over the past 5 years developing a satellitebased telecommunication system in the Philippines, headquartered in the northern region of Luzon. It is currently contemplating whether to spend an additional Php350 million on the project. After this outlay, the project is expected to be finished and will generate annual cash flow of Php25 million per year over the next ten years, as guaranteed by a reliable projection. A giant telecommunication competitor is offering the company Php750 million for its satellites. Classify the companys capital outlays as sunk costs, opportunity costs, operating cash flow or incremental cost and specify the relevant cash flows for decision making. Answers: Php4.5billion sunk cost; irrelevant

XMAFIN2 CAPITAL BUDGETING, CASH FLOWS


Php350 million incremental cost; relevant Php25 million (annual, 10 years) operating cash inflow; relevant Php750 million opportunity cost; relevant

The relevant cash flows necessary for a conventional capital budgeting project are the incremental after-tax cash flows attributable to the proposed project: the initial investment, the operating cash inflows, and the terminal cash flow. The initial investment is the initial outlay required, taking into account the installed cost of the new asset, proceeds from the sale of the old asset, tax on the sale of the old asset, and any change in net working capital. The operating cash inflows are the additional cash flows received as a result of implementing a proposal. Terminal cash flow represents the after-tax cash flows expected to result from the liquidation of the project at the end of its life. These three components represent the positive or negative cash flow impact if the firm implements the project and are depicted in the following diagram for a project lasting five years.

COMPUTATIONS FOR THE MAJOR CASH FLOW COMPONENTS OF A CAPITAL BUDGET


A. INITIAL INVESTMENT
A.1 Basic Format for Determining Initial Investment (write your formula here)

The cost of the new asset is the purchase price. (Outflow) b. Installation costs are any added costs necessary to get an asset into operation. (Outflow) c. Proceeds from sale of old asset are cash inflows resulting from the sale of an existing asset, reduced by any removal costs. (Inflow) d. Tax on sale of old asset is incurred when the replaced asset is sold due to recaptured depreciation, capital gain, or capital loss. (May be an inflow or an outflow) e. The change in net working capital is the difference between the change in current assets and the change in current liabilities. (May be an inflow or an outflow) The asset may be sold (1) for more than its book value, (2) for the amount of its book value, or (3) at a price below book value. In the first case, taxes arise from the amount by which the sale price exceeded the book value. In the second case, no taxes would be required. In the third case, a tax credit would occur. The depreciable value of an asset is the installed cost of a new asset and is based on the depreciable cost of the new project, including installation cost.

XMAFIN2 CAPITAL BUDGETING, CASH FLOWS


EXERCISE: ( sheet of yellow paper, 5 minutes)
Change in Net Working Capital. A corporation is considering expanding operations to meet growing demand. With the capital expansion the current accounts are expected to change. Management expects cash to increase by Php500, 000, accounts receivable by Php1, 000, 000, and inventories by Php1, 500,000. At the same time accounts payable will increase by Php2, 000, 000, accruals by Php1, 500, 000, and long-term debt by Php4, 000, 000. The change in net working capital is A) an increase of Php500,000. B) a decrease of Php500,000. C) a decrease of Php4,500,000. D) an increase of Php4,000,000. Change in Net Working Capital. If accounts receivable increase by Php1,000,000, inventory decreases by Php500,000, and accounts payable increase by Php500,000, net working capital would A) decrease by 500,000. B) increase by 1,500,000. C) increase by 2,000,000. D) experience no change.

EXERCISE: (1/4 sheet of yellow paper, 5 minutes)


Finding the Initial Investment. The Medical City is planning to purchase a high-powered microscopy machine for Php2,750,000 and incur an additional Php375,000 in installation expenses. It is replacing similar microscopy equipment that can be sold for Php1,750, 000, with corresponding tax on the gain on sale of Php562,500. Because of this transaction, a positive change in Net Working Capital of 100,000 will be realized. Calculate the initial investment needed for the acquisition of the asset. Php2, 037, 500 Finding the Initial Investment. A corporation has decided to replace an existing asset with a newer model. The asset, which is now 52% depreciated, was originally acquired Php1, 500, 000. The existing asset can be sold for Php1, 250, 000. The new asset will cost Php3, 750, 000. If the assumed tax rate is 40 percent on ordinary income and capital gains, the initial investment is ________. A) Php2,100, 000 B) Php2, 622, 000 C) Php2, 712, 000 D) Php2, 500, 000 Proceeds from Sale of Old Asset Tax & Depreciation. A corporation is selling an existing asset for Php1,050,000 due to market appreciation. The asset, which is now 83% depreciated, was originally acquired for Php500, 000. If the assumed tax rate is 40 percent on ordinary income and capital gains, the tax effect of this transaction is: A) Php0 tax liability. B) Php378, 000 tax liability. C) Php220, 000 tax liability. D) Php386, 000 tax liability. Proceeds from Sale of Old Asset Tax & Depreciation. A corporation is selling an existing asset for Php50,000. The asset, which is now 83% depreciated, was originally acquired at Php500,000. If the assumed tax rate is 40 percent on ordinary income and capital gains, the tax effect of this transaction is: A) Php0 tax liability. B) Php55, 000 tax liability. C) Php180, 000 tax liability. D) Php14, 000 tax benefit. To calculate incremental after-tax operating cash inflow for both the existing situation and the proposed project, the depreciation on assets is added back to the after-tax profits to get the cash flows associated with each alternative. The difference between the cash flows of the proposed and present situation, the incremental after-tax cash flows, are the relevant operating cash flows used in evaluating the proposed project. B. AFTER-TAX INCREMENTAL CASH INFLOW B.1. Basic Format for Determining After-tax Incremental Cash Inflow (write your formula here)

XMAFIN2 CAPITAL BUDGETING, CASH FLOWS


EXERCISE: ( sheet of yellow paper, 10 minutes) Finding the Incremental After-tax Cash Inflows

Business Solutions, Inc. Statement of Revenue and Expenses for Proposed & Present Machines
Proposed Machine (Php 8,000,000) Year Revenue Exp (excl. depr. & int.) 1 50,400,000 46,000,000 2 50,400,000 46,000,000 3 50,400,000 46,000,000 4 50,400,000 46,000,000 5 50,400,000 46,000,000 *Assume the following depreciation rates for years 1-6: 20%, 32%, 19%, 12%, 12%, & 5% (applying MACRS) Present Machine (Php 4,800,000) Year Revenue Exp (excl. depr. & int.) 1 44,000,000 39,800,000 2 46,000,000 42,200,000 3 48,000,000 44,600,000 4 48,000,000 45,000,000 5 45,000,000 42,400,000 *Assume that the present machine has already been depreciated for 3 years, and applying MACRS, it will be depreciated for 3 years more, that is years 13: 12%, 12%, 5%

1. Compute for the annual depreciation under (a) Proposed Machine & (b) Present Machine 2. Compute for the Operating Cash Inflows under (a) Proposed Machine & (b) Present Machine, assuming tax rate of 40%. How much is the Incremental After-tax Cash Inflow should the firm purchase the Proposed Machine? C. TERMINAL CASH FLOW The terminal cash flow is the cash flow resulting from termination and liquidation of a project at the end of its economic life. The form of calculating terminal cash flows is shown below: Terminal Cash Flow Calculation: After-tax proceeds from sale of new asset After-tax proceeds from sale of old asset Change in net working capital Terminal cash flow

Extended Presentation: Proceeds from sale of new asset Tax on sale of new asset Proceeds from sale of old asset Tax on sale of old asset Change in net working capital Terminal cash flow

Finding the Terminal Cash Flow (1/2 yellow paper, 10 minutes) Tooner Industries is currently analyzing the purchase of a new machine that costs Php3, 200, 000 and requires Php 400, 000 in shipping and installation expenses. The depreciable amount is equal to installed cost of the proposed asset less salvage value of Php200, 000. Acquiring this machine will result to a positive change in Net Working Capital of Php600, 000. The machine will be useful for 10 years, and will be depreciated using the SYD method. Determine the terminal cash flow of the machine should the company disposes it after (assume tax rate of 40%): a. 3 years (with selling price of Php3, 500, 000 before tax) b. 5 years (with selling price of Php500, 000 before tax) c. 10 years (with selling price of Php200, 000 before tax) Answer: Depreciable amount = (3,200,000 + 400,000) 200,000 SV = Php3, 600, 000 Depreciation Method: Sum of the years Digit = Life [(Life + 1)/2] Book Value (dont forget
to add back SV of Php200, 000)

Depreciated Undepreciated Portion Portion

Terminal Cash Flow of the proposed machine 3,472,364 1,350,909 800,000

(a) after 3 years: (b) after 5 years: (c) after 10 years:

27/55 40/55 55/55

28/55 15/55 0

1,930,909 1,127,273 200,000

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