Download Capital Budgeting Processes And Techniques

Chapter 8:
Cash Flow and
Capital Budgeting
Corporate Finance, 3e
Graham, Smart, and Megginson
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Cash Flow and Capital Budgeting
 Types of cash flows that may appear in
almost any type of investment
 How to deal properly with the problem of
inflation in capital budgeting problems
 Special problems and situations that arise in
the capital budgeting process
 The human element in capital budgeting
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Cash Flow Versus Accounting Profit
preparing financial statements for
external reporting, accountants have a
different purpose in mind than financial
analysts have.
 In
 Accountants
measure the inflows and outflows
of a business’s operations on an accrual basis
rather than on a cash basis.
 e.g.,
depreciation
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Cash Flow Versus Accounting Profit

For capital budgeting purposes, financial
analysts focus on cash flows.
 No
matter what earnings a firm may show on an
accrual basis, it cannot survive for long unless it
generates cash to pay its bills.

When calculating a project’s cash flows, analysts
should…
 Include
the effects of taxes.
 Ignore interest expense.
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Types of Cash Flows
 Depreciation
 Fixed
asset expenditures
 Working
capital expenditures
 Terminal
value
 Incremental
cash flow
 Opportunity
costs
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Depreciation
 Largest
noncash item for most investment
 Affects
the amount of taxes the firm will
projects
pay
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Two Methods of Handling Depreciation
to Compute Cash Flow
Assume a firm purchases a fixed asset today for
$30,000
Plans to depreciate over 3 years using straight-line
method
Firm will produce
10,000 units/year
Costs $1/unit
Sells for $3/unit
Firm pays taxes at a 40% marginal rate
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Depreciation



Many countries allow firms to use one depreciation
method for tax purposes and another for reporting
purposes.
Accelerated depreciation methods such as the modified
accelerated cost recovery system (MACRS) increase the
present value of an investment’s tax benefits.
Relative to MACRS, straight-line depreciation results in
higher reported earnings early in an investment’s life.
Which method would you expect companies to use when they file
their taxes, and which would they use when preparing public
financial statements?
For capital budgeting analysis, it is the depreciation
method for tax purposes that matters.
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Sale of Old Equipment

When a firm sells an old piece of equipment,
there will be a tax consequence of the sale if the
selling price exceeds or falls below the old
equipment’s book value.
 If
the firm sells an asset for more than its book value,
the firm must pay taxes on the difference.
 If a firm sells an asset for less than its book value,
then it can treat the difference as a tax-deductible
expense.
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Working Capital Expenditures

Many capital investments require additions to
working capital.
 Net
working capital (NWC) = Current assets minus
current liabilities
 An increase in NWC requires a cash outflow, while a
decrease creates a cash inflow.
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Terminal Value
Terminal value used when evaluating an investment
with indefinite life-span
Construct cash-flow
forecasts for 5 to 10 years
Forecasts more than 5 to 10
years have high margin of
error; use terminal value
instead.
• Terminal value is intended to reflect the value of
a project at a given future point in time.
– Large value relative to all the other cash flows
of the project
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Terminal Value
Different ways to calculate terminal values
– Use final year cash flow projections and assume that
all future cash flows grow at a constant rate.
– Multiply final cash flow estimate by a market multiple.
– Use investment’s book value or liquidation value.
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Incremental Cash Flow
Incremental cash flows versus sunk costs
Capital budgeting analysis should include only
incremental costs.
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Opportunity Costs
 In
capital budgeting, the opportunity costs
of one investment are the cash flows on
the alternative investment that the firm
decides not to make.
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Opportunity Costs
Cash flows from alternative investment
opportunities, forgone when one investment is
undertaken
If Norm did not attend school, he would have
earned:
First year: $70,000
($45,500 after taxes)
Second Year: $73,500
($47,775 after taxes)
NPV of a project could fall substantially if opportunity costs are
recognized.
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Cash Inflows, Discounting, and
Inflation

If inflation is in the numerator, be sure that it is also in
the denominator.

The nominal return reflects the actual dollar return.

The real return measures the increase in purchasing
power gained by holding a certain investment.

In general, when the inflation rate is high, so too will
be the nominal rate of return offered by various
investments:
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Inflation Rule 1
 Nominal
cash flows reflect the same
inflation rate that the interest rate does.
 Inflation
Rule 1 — When we discount
cash flows at a nominal interest rate,
embedded in the discount rate is an
estimate of expected inflation.
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Inflation Rule 2
 Occasionally
an investment’s cash flow
projections may be stated in real terms.
 Real
cash flows only reflect current prices
and do not incorporate upward
adjustments for expected inflation.
 Inflation
Rule 2 — When project cash
flows are stated in real rather than in
nominal terms, the appropriate discount
rate is the real rate.
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Special Problems in Capital
Budgeting
 Equipment
replacement and equivalent
annual cost
 Excess
capacity
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Excess Capacity
When firms operate at less than full capacity,
managers encourage alternative uses of the
excess capacity because they view it as a free
asset.
 The marginal cost of using excess capacity is
zero in the very short run, but using excess
capacity today may accelerate the need for more
capacity in the future.
 When this is so, managers should charge the
cost of accelerating new capacity development
against the current proposal for using excess
capacity.
 Excess capacity – not a free asset as traditionally
regarded by managers.

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Human Face of Capital
Budgeting
 The
best financial analysts can provide not
only the numbers to highlight the value of
a good investment, but also can explain
why the investment makes sense,
highlighting the competitive opportunity
that makes one investment’s NPV positive
and another’s negative.
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