Chapter 8

Capital Budgeting
Cash Flow
Learning Goals

1. Understand the motives for key capital

budgeting expenditures and the steps in
the capital budgeting process.
2. Define basic capital
budgeting terminology.
3. Discuss relevant cash flows, expansion
versus replacement decisions, sunk
costs and opportunity costs, and
international capital budgeting.
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Learning Goals (cont.)

4. Calculate the initial investment

associated with a proposed
capital expenditure.
5. Find the relevant operating cash inflows
associated with a proposed
capital expenditure.
6. Determine the terminal cash flow
associated with a proposed
capital expenditure.
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The Capital Budgeting Decision

Capital Budgeting is the process of identifying,

evaluating, and implementing a firms investment
opportunities.
It seeks to identify investments that will enhance a
firms competitive advantage and increase
shareholder wealth.
The typical capital budgeting decision involves a
large up-front investment followed by a series of
smaller cash inflows.
Poor capital budgeting decisions can ultimately
result in company bankruptcy.
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Motives for Capital Expenditures

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Steps in the Process

1. Proposal Generation

2. Review and Analysis

3. Decision Making
Our Focus

4. Implementation

5. Follow-up

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Basic Terminology: Independent versus
Mutually Exclusive Projects
Independent Projects, on the other
hand, do not compete with the firms
resources. A company can select one, or
the other, or bothso long as they meet
minimum profitability thresholds.
Mutually Exclusive Projects are
investments that compete in some way for
a companys resourcesa firm can select
one or another but not both.
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Basic Terminology: Unlimited Funds
versus Capital Rationing
If the firm has unlimited funds for making
investments, then all independent projects
that provide returns greater than some specified
level can be accepted and implemented.
However, in most cases firms face capital
rationing restrictions since they only have a
given amount of funds to invest in potential
investment projects at any given time.

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Basic Terminology: Accept-Reject
versus Ranking Approaches
The accept-reject approach involves the
evaluation of capital expenditure
proposals to determine whether they meet
the firms minimum acceptance criteria.
The ranking approach involves the
ranking of capital expenditures on the
basis of some predetermined measure,
such as the rate of return.
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Basic Terminology: Conventional
versus Nonconventional Cash Flows

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Basic Terminology: Conventional versus
Nonconventional Cash Flows (cont.)

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The Relevant Cash Flows

Incremental cash flows:

are cash flows specifically associated with the
investment, and
their effect on the firms other investments
(both positive and negative) must also be
considered.
For example, if a day-care center decides to open another
facility, the impact of customers who decide to move from
one facility to the new facility must be considered.

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Relevant Cash Flows:
Major Cash Flow Components

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Relevant Cash Flows: Expansion
Versus Replacement Decisions
Estimating incremental cash flows is
relatively straightforward in the case of
expansion projects, but not so in the
case of replacement projects.
With replacement projects, incremental
cash flows must be computed by
subtracting existing project cash flows
from those expected from the new project.
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Relevant Cash Flows: Expansion
Versus Replacement Cash Flows

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Relevant Cash Flows: Sunk Costs
Versus Opportunity Costs
Note that cash outlays already made
(sunk costs) are irrelevant to the
decision process.
However, opportunity costs, which are
cash flows that could be realized from the
best alternative use of the asset,
are relevant.

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Relevant Cash Flows: International
Capital Budgeting
International capital budgeting analysis differs
from purely domestic analysis because:
cash inflows and outflows occur in a foreign
currency, and
foreign investments potentially face significant
political risks

Despite these risks, the pace of foreign direct

investment has accelerated significantly since
the end of WWII.

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Finding the Initial Investment

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Finding the Initial Investment (cont.)

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Finding the Initial Investment (cont.)

Hudson Industries, a small electronics company, 2

years ago acquired a machine tool with an installed
cost of $100,000. The asset was being depreciated
under MACRS using a 5-year recovery period. Thus
52% of the cost (20% + 32%) would represent
accumulated depreciation at the end of year two.

Book Value = $100,000 - $52,000 = $48,000

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Finding the Initial Investment

Sale of the Asset for More Than Its Purchase Price

If Hudson sells the old asset for $110,000, it realizes a

gain of $62,000 ($110,000 - $48,000). Technically, the
difference between the cost and book value ($52,000) is
called recaptured depreciation and the difference
between the sales price and purchase price ($10,000) is
called a capital gain. Under current corporate tax laws,
the firm must pay taxes on both the gain and recaptured
depreciation at its marginal tax rate.
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Finding the Initial Investment (cont.)

Sale of the Asset for More Than Its Book Value

but Less than Its Purchase Price

If Hudson sells the old asset for $70,000, it realizes

a gain in the form of recaptured depreciation of
$22,000 ($70,000$48,000) which is taxed at the
firms marginal tax rate.

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Finding the Initial Investment (cont.)

Sale of the Asset for Its Book Value

If Hudson sells the old asset for its book value of

$48,000, there is no gain or loss and therefore no tax
implications from the sale.

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Finding the Initial Investment (cont.)

Sale of the Asset for Less Than Its Book Value

If Hudson sells the old asset for $30,000 which is less than
its book value of $48,000, it experiences a loss of $18,000
($48,000 - $30,000). If this is a depreciable asset used in
the business, the loss may be used to offset ordinary
operating income. If it is not depreciable or used in the
business, the loss can only e used to offset capital gains.

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Finding the Initial Investment (cont.)

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Finding the Initial Investment (cont.)

Change in Net Working Capital

Danson Company, a metal products manufacturer, is

contemplating expanding operations. Financial analysts
expect that the changes in current accounts summarized
in Table 8.4 on the following slide will occur and will be
maintained over the life of the expansion.

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Finding the Initial Investment (cont.)

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Finding the Initial Investment (cont.)

Powell Corporation, a large diversified manufacturer of aircraft

components, is trying to determine the initial investment required
to replace an old machine with a new, more sophisticated model.
The machines purchase price is $380,000 and an additional
$20,000 will be necessary to install it. It will be depreciated
under MACRS using a 5-year recovery period. The firm has
found a buyer willing to pay $280,000 for the present machine
and remove it at the buyers expense. The firm expects that a
$35,000 increase in current assets and an $18,000 increase in
current liabilities will accompany the replacement. Both ordinary
income and capital gains are taxed at 40%.
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Finding the Initial Investment (cont.)

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 Finding the Operating Cash Inflows

Powell Corporations estimates of its revenues and expenses

(excluding depreciation and interest), with and without the new
machine described in the preceding example, are given in
Table 8.5. Note that both the expected usable life of the
proposed machine and the remaining usable life of the existing
machine are 5 years. The amount to be depreciated with the
proposed machine is calculated by summing the purchase
price of $380,000 and the installation costs of $20,000.

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Finding the Operating
Cash Inflows (cont.)

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Finding the Operating
Cash Inflows (cont.)

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Finding the Operating
Cash Inflows (cont.)

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Finding the Operating
Cash Inflows (cont.)

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Finding the Operating
Cash Inflows (cont.)

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Finding the Terminal Cash Flow

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 Finding the Terminal Cash Flow (cont.)

Continuing with the Powell Corporation example, assume that

the firm expects to be able to liquidate the new machine at the
end of its 5-year useable life to net $50,000 after paying
removal and cleanup costs. The old machine can be
liquidated at the end of the 5 years to net $10,000. The firm
expects to recover its $17,000 net working capital investment
upon termination of the project. Again, the tax rate is 40%.

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Finding the Terminal Cash Flow (cont.)

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Summarizing the Relevant Cash Flows

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