Martin' Keown, Petty, Scott

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Cash Flows and Other Topics in Capital Budgeting
Chapter 10
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• Learning Objectives
• Discuss what is and what is not an incremental
  cash flow, and why they alone are relevant in
  capital-budgeting decisions.
• Explain how a projects benefits and coststhat
  is, its incremental after-tax cash flowsare
  calculated.
• Explain how the capital-budgeting decision
  process changes when a limit is placed on the
  dollar size of the capital budget.

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Cash Flows in General
Measure Incremental Cash Flows

• Measure cash flows that change if a project is
  undertaken
• Sunk cost is irrelevant
• Opportunity cost is relevant
• Do not include allocation of existing overhead
• Do subtract lost sales of other products
• Include cost savings as a positive cash flow.

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Cash Flows in General

• New Project vs. Replacement Project
• New project simply addition to company
• Replacement replace and existing old machine or
  plant.
• Financing costs - Interest and Dividend payments.
  are not considered operating cash flows.
  Financing cost are used to discount the cash
  flows to find NPV,etc.
• Only include CASH inflows and outflows.

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Estimating Cash Flows
Three Types of Cash Flows

• Initial Outlay

Initial Outlay
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Estimating Cash Flows
Three Types of Cash Flows

• Initial Outlay
• Operating (Differential) Cash Flows

Initial Outlay
Operating Cash Flows
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Estimating Cash Flows
Three Types of Cash Flows

• Initial Outlay
• Operating (Differential) Cash Flows
• Terminal Cash Flow

Initial Outlay
Terminal Cash Flow
Operating Cash Flows
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Estimating Cash Flows
Initial Outlay

• Cost of Assets
• Installation and Shipping
• Non-Expense Outlays (i.e. Working Capital)
• Expense Outlays after tax (i.e. Training Expenses)

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Estimating Cash Flows
Initial Outlay

• Cost of Assets
• Installation and Shipping
• Non-Expense Outlays (i.e. Working Capital)
• Expense Outlays after tax (i.e. Training Expenses)

Only for Replacement Projects

• Sale of Old Machine

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Estimating Cash Flows
Initial Outlay

• Cost of Assets
• Installation and Shipping
• Non-Expense Outlays (i.e. Working Capital)
• Expense Outlays after tax (i.e. Training Expenses)

Only for Replacement Projects

• Sale of Old Machine
• Taxes on Machine

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Estimating Cash Flows
Initial Outlay
Example Gasperini Corp. is considering replacing
their old production machine with a new one. The
cost of the new machine is 48,000 installation
and delivery cost 2,000. Working Capital
requirements on the new machine are 3,000
immediately, and training costs amount to 4,000.
The old machine can be sold for 10,000 its book
value is zero. Gasperini has a marginal tax rate
of 40.
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Estimating Cash Flows
Initial Outlay
Cost of Machine 48,000
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Estimating Cash Flows
Initial Outlay
Cost of Machine 48,000 Installation
Shipping 2,000
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Estimating Cash Flows
Initial Outlay
Cost of Machine 48,000 Installation
Shipping 2,000 Working Capital 3,000
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Estimating Cash Flows
Initial Outlay
Cost of Machine 48,000 Installation
Shipping 2,000 Working Capital 3,000 Training
(after tax) 2,400
4,000(1-0.40)
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Estimating Cash Flows
Initial Outlay
Cost of Machine 48,000 Installation
Shipping 2,000 Working Capital 3,000 Training
(after tax) 2,400 55,400 Less Sale of Old
Machine
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Estimating Cash Flows
Initial Outlay
Cost of Machine 48,000 Installation
Shipping 2,000 Working Capital 3,000 Training
(after tax) 2,400 55,400 Less Sale of Old
Machine Salvage Value 10,000
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Estimating Cash Flows
Initial Outlay
Cost of Machine 48,000 Installation
Shipping 2,000 Working Capital 3,000 Training
(after tax) 2,400 55,400 Less Sale of Old
Machine Salvage Value 10,000 Taxes 4,000
Tax rate x (Salvage Value-Book Value)
.4(10,000 0)
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Estimating Cash Flows
Initial Outlay
Cost of Machine 48,000 Installation
Shipping 2,000 Working Capital 3,000 Training
(after tax) 2,400 55,400 Less Sale of Old
Machine Salvage Value 10,000 Taxes 4,000
6,000
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Estimating Cash Flows
Initial Outlay
Cost of Machine 48,000 Installation
Shipping 2,000 Working Capital 3,000 Training
(after tax) 2,400 55,400 Less Sale of Old
Machine Salvage Value 10,000 Taxes 4,000
6,000 Initial Outlay 49,400
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Estimating Cash Flows
Initial Outlay
Cost of Machine 48,000 Installation
Shipping 2,000 Working Capital 3,000 Training
(after tax) 2,400 55,400 Less Sale of Old
Machine Salvage Value 10,000 Taxes 4,000
6,000 Initial Outlay 49,400
-49,400
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Estimating Cash Flows
Terminal Cash Flow
Example Gasperini Corp. is considering replacing
their old production machine with a new one. The
cost of the new machine is 48,000 installation
and delivery cost 2,000. Working Capital
requirements on the new machine are 3,000
immediately, and training costs amount to 4,000.
The old machine can be sold for 10,000 its book
value is zero. Gasperini has a marginal tax rate
of 40. The new machine Gasperini Corp is
considering buying will increase revenues by
5,000/yr and decrease costs by 8,000/ yr. They
expect to use the machine for 5 years, and expect
to sell it for 15,000 in 5 years. Assume
Gasperini uses the Simplified Straight Line
method to depreciate assets.
Recover Working Capital 3,000
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Estimating Cash Flows
Terminal Cash Flow
Example Gasperini Corp. is considering replacing
their old production machine with a new one. The
cost of the new machine is 48,000 installation
and delivery cost 2,000. Working Capital
requirements on the new machine are 3,000
immediately, and training costs amount to 4,000.
The old machine can be sold for 10,000 its book
value is zero. Gasperini has a marginal tax rate
of 40. The new machine Gasperini Corp is
considering buying will increase revenues by
5,000/yr and decrease costs by 8,000/ yr. They
expect to use the machine for 5 years, and expect
to sell it for 15,000 in 5 years. Assume
Gasperini uses the Simplified Straight Line
method to depreciate assets.
Recover Working Capital 3,000 Sell New
Machine 15,000
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Estimating Cash Flows
Terminal Cash Flow
Example Gasperini Corp. is considering replacing
their old production machine with a new one. The
cost of the new machine is 48,000 installation
and delivery cost 2,000. Working Capital
requirements on the new machine are 3,000
immediately, and training costs amount to 4,000.
The old machine can be sold for 10,000 its book
value is zero. Gasperini has a marginal tax rate
of 40. The new machine Gasperini Corp is
considering buying will increase revenues by
5,000/yr and decrease costs by 8,000/ yr. They
expect to use the machine for 5 years, and expect
to sell it for 15,000 in 5 years. Assume
Gasperini uses the Simplified Straight Line
method to depreciate assets.
Recover Working Capital 3,000 Sell New
Machine 15,000 Tax on Sale -6,000
.4(15,000-0)
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Estimating Cash Flows
Terminal Cash Flow
Example Gasperini Corp. is considering replacing
their old production machine with a new one. The
cost of the new machine is 48,000 installation
and delivery cost 2,000. Working Capital
requirements on the new machine are 3,000
immediately, and training costs amount to 4,000.
The old machine can be sold for 10,000 its book
value is zero. Gasperini has a marginal tax rate
of 40. The new machine Gasperini Corp is
considering buying will increase revenues by
5,000/yr and decrease costs by 8,000/ yr. They
expect to use the machine for 5 years, and expect
to sell it for 15,000 in 5 years. Assume
Gasperini uses the Simplified Straight Line
method to depreciate assets.
Recover Working Capital 3,000 Sell New
Machine 15,000 Tax on Sale -6,000 Terminal Cash
Flow 12,000
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Capital Rationing

• In large companies, many projects are evaluated
  each year
• Management often imposes a limit that can be
  spent on new projects adopted during the
  yearCapital Rationing
• In order to allocate scarce resources, choose
  the group of projects whose initial outlays are
  within the capital spending limit while at the
  same time maximizing NPV of the group of
  projects.

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Capital Rationing
Example
The following independent projects are subject to
a 100,000 capital budget.
Project IO NPV PI 1 50,000 1,500 1.03 2 40,000 3,0
00 1.075 3 30,000 2,500 1.083 4 20,000 1,000 1.05
5 90,000 6,000 1.067
All Projects have NPV gt 0, PI gt 1
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Capital Rationing
Example
Project Combinations IO NPV
2, 3 4 40,000 3,000 30,000 2,500 20,000 1,
000 90,000 6,500
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Capital Rationing
Example
Project Combinations IO NPV
2, 3 4 40,000 3,000 30,000 2,500 20,000 1,
000 90,000 6,500 5 90,000 6,000
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Capital Rationing
Example
Project Combinations IO NPV
2, 3 4 40,000 3,000 30,000 2,500 20,000 1,
000 90,000 6,500 5 90,000 6,000 1
2 50,000 1,500 40,000 3,000 90,000 4,500
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Capital Rationing
Example
Project Combinations IO NPV
2, 3 4 40,000 3,000 30,000 2,500 20,000 1,
000 90,000 6,500 5 90,000 6,000 1
2 50,000 1,500 40,000 3,000 90,000 4,500 1,3
4 50,000 1,500 30,000 2,500 20,000 1,000 100,00
0 5,000
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Capital Rationing
Example
Project Combinations IO NPV
2, 3 4 40,000 3,000 30,000 2,500 20,000 1,
000 90,000 6,500 5 90,000 6,000 1
2 50,000 1,500 40,000 3,000 90,000 4,500 1,3
4 50,000 1,500 30,000 2,500 20,000 1,000 100,00
0 5,000
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