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Objectives
Discuss relevant cash flows and the three major cash flow components. Calculate the initial investment, operating cash inflows, and terminal cash flow associated with a proposed capital expenditure. Understand the importance of recognizing risk in the analysis of capital budgeting projects, and discuss risk and cash inflows and break-even analysis as a behavioral approach for dealing with risk. Describe the determination and use of risk-adjusted discount rates (RADRs), portfolio effects, and the practical aspects of RADRs. Select the best of a group of projects using the procedures for capital rationing.
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Incremental cash flows are the changes in cash flows outflows or inflowsthat occur when the firm makes a new capital expenditure.
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2. Operating cash inflows: the incremental after-tax net cash inflows resulting from implementation of a project during its life.
3. Terminal cash flow: the after-tax nonoperating cash flow occurring in the final year of a project. It is usually attributable to liquidation of the project.
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The installed cost of new asset is the cost of new asset plus its installation costs; equals the assets depreciable value.
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Finding the Initial Investment: After-Tax Proceeds from Sale of Old Asset
The after-tax proceeds from sale of old asset is the cash flow associated with selling an old asset which includes the old assets selling price as well as any taxes or tax refunds triggered by the sale. The tax on sale of old asset is tax that depends on the relationship between the old assets sale price and book value and on existing government tax rules. Book value is the strict accounting value of an asset, calculated by subtracting its accumulated depreciation from its installed cost. Book value = Installed cost of asset Accumulated depreciation
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Finding the Initial Investment: After-Tax Proceeds from Sale of Old Asset (cont.)
Hudson Industries, a small electronics company, 2 years ago acquired a machine tool with an installed cost of $100,000. Under MACRS for a 5-year recovery period, 20% and 32% of the installed cost would be depreciated in years 1 and 2, respectively. In other words, 52% (20% + 32%) of the $100,000 cost, or $52,000 (0.52 $100,000), would represent the accumulated depreciation at the end of year 2. The book value of Hudsons asset at the end of year 2 is therefore $100,000 $52,000 = $48,000.
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Finding the Initial Investment: After-Tax Proceeds from Sale of Old Asset (cont.)
If Hudson sells the old asset for $110,000, it realizes a gain of $62,000 ($110,000 $48,000).
This gain is made up of two partsa capital gain and recaptured depreciation, which is the portion of an assets sale price that is above book value and below its initial purchase price.
The capital gain is $10,000 ($110,000 sale price $100,000 initial purchase price); recaptured depreciation is $52,000 (the $100,000 initial purchase price $48,000 book value).
The total gain above book value of $62,000 is taxed as ordinary income at the 40% rate, resulting in taxes of $24,800 (0.40 $62,000).
2012 Pearson Prentice Hall. All rights reserved.
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Finding the Initial Investment: After-Tax Proceeds from Sale of Old Asset (cont.) However, if the asset is sold for $48,000, its book value, the firm breaks even. Since no tax results from selling an asset for its book value, there is no tax effect on the initial investment in the new asset.
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Finding the Initial Investment: After-Tax Proceeds from Sale of Old Asset
If Hudson sells the asset for $30,000, it experiences a loss of $18,000 ($48,000 $30,000). If this is a depreciable asset used in the business, the firm may use the loss to offset ordinary operating income. If the asset is not depreciable or is not used in the business, the firm can use the loss only to offset capital gains. In either case, the loss will save the firm $7,200 (0.40 $18,000) in taxes. If current operating earnings or capital gains are not sufficient to offset the loss, the firm may be able to apply these losses to prior or future years taxes.
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If the change in net working capital were negative, it would be shown as an initial inflow.
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The proceeds from sale of the new and the old asset, often called salvage value, represent the amount net of any removal or cleanup costs expected upon termination of the project.
If the net proceeds from the sale are expected to exceed book value, a tax payment shown as an outflow (deduction from sale proceeds) will occur. When the net proceeds from the sale are less than book value, a tax rebate shown as a cash inflow (addition to sale proceeds) will result.
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After-Tax Gain on proposed machine is $50,000 - $20,000 = $30,000 Tax on sale of proposed machine = $30,000 x 0.40 = $12,000
2012 Pearson Prentice Hall. All rights reserved.
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The financial manager of Bennett has assigned project A to class III and project B to class II. The cash flows for project A would be evaluated using a 14% RADR, and project Bs would be evaluated using a 10% RADR. The NPV of project A at 14% is now calculated to be $6,063 instead of $11,074 at 10%, while the NPV for project B which maintains a 10% RADR is $10,924.
2012 Pearson Prentice Hall. All rights reserved.
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Calculation of NPVs for Bennett Companys Capital Expenditure Alternatives Using RADRs
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Capital Rationing
Firms often operate under conditions of capital rationingthey have more acceptable independent projects (with positive NPV) than they can fund. In theory, capital rationing should not existfirms should accept all projects that have positive NPVs. However, in practice, most firms operate under capital rationing. Generally, firms attempt to isolate and select the best acceptable projects subject to a capital expenditure budget set by management.
2012 Pearson Prentice Hall. All rights reserved.
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Capital Rationing
Specific targets set on the usage of funds that can be invested in a given period:
Reasons why rationing may be adopted include:
Fear of too much spending growth Hesitation to use external sources of funding Economic uncertainty Justification for management approval process
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Target = $5M
1 = Strategic Support, 2 = Required to support existing Capability, 3 = Needed but can be pushed to 07, 4 = Pushed to07
Chapter Summary
The relevant cash flows for capital budgeting decisions are the incremental cash outflow (investment) and resulting subsequent inflows associated with a proposed capital expenditure. The three major cash flow components of any project can include: (1) an initial investment, (2) operating cash inflows, and (3) terminal cash flow. The initial investment occurs at time zero, the operating cash inflows occur during the project life, and the terminal cash flow occurs at the end of the project. For replacement decisions, the relevant cash flows are the difference between the cash flows of the new asset and the old asset. Expansion decisions are viewed as replacement decisions in which all cash flows from the old asset are zero. When estimating relevant cash flows, ignore sunk costs and include opportunity costs as cash outflows. The initial investment is the initial outflow required, taking into account the installed cost of the new asset, the after-tax proceeds from the sale of the old asset, and any change in net working capital. The operating cash inflows are the incremental after-tax cash inflows expected to result from a project.
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