Chapter 8 Capital Budgeting and Cash Flow Analysis

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Chapter 8Capital Budgeting and Cash Flow Analysis

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Introduction

• This chapter discusses capital budgeting and
  capital expenditures.
• It also deals with the financial management of
  the fixed assets on a firms balance sheet.

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• Capital Budgeting
• The process of planning for purchases of
  assets whose returns are expected to continue
  beyond a year
• Capital Expenditure
• A cash outlay expected to generate a flow of
  future cash benefits for more than a year
• Capital Budgeting decisions can be the most
  complex and strategic decisions facing
  management.
• Should tie into the three and five-year plans

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Capital Expenditure Decisions

• Replacement
• Expand an existing product line
• Enter a new line of business
• Refunding a bond issue
• Leasing
• Mergers and
  acquisitions

• Working capital
• Permanent increases in inventory or receivables
• Advertising campaign
• R and D
• Education and training (such as Clemson)
• Modifications to coliseums (such as Littlejohn)

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Cost of Capital

• Firms overall cost of funds (MCC)
• Investors required rate of return
• Provides a basis for evaluating capital
  investment projects
• Can make adjustments for risk
• Also called the hurdle rate
• With the MCC (or WACC) method, do not include
  specific financing costs.
• Do not include interest on debt.
• You will learn how to calculate the cost of
  capital in Finance 312.

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How Are Projects Classified

• Independent
• Acceptance or rejection has no effect on other
  projects
• Mutually Exclusive
• Acceptance of one automatically rejects the
  others
• Contingent
• Acceptance is dependent upon the selection of
  another project (may be a Strategic Option)

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Mutually Exclusive Projects

• Purchase new machine
• Purchase used machine
• Rent machine
• Repair old machine

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Capital Rationing

• Most companies have a limited amount of
  dollars available for investment
• Funds constraint

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Basic Framework for Capital Budgeting

• Expand capital budget until marginal revenue
  equals marginal cost
• Invest in the most profitable projects first
• Investment Opportunity Curve
• Continue accepting projects as long as the rate
  of return exceeds the MCC (theoretically)

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Capital Budgeting Problems

• All projects may not be known at one time
• Changing markets, global competition, technology,
  and corporate strategies can make current
  projects obsolete and make new ones profitable
• Difficulty in determining the behavior of and
  changes in the MCC
• Estimates of CFs have varying degrees of
  uncertainty and risk

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Capital Budgeting Process

• Generate capital investment projects
• Search for investment opportunities
• Estimate Cash Flows, and estimate the Weighted
  Average Cost of Capital (ka)
• Consider the project risks involved
• Evaluate the alternatives and rank and choose
  among competing projects
• Review or post-audit prior investment decisions

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Capital Budgeting Process

• Step 1
• Generating proposals
• Step 2
• Estimating CFs
• Step 3
• Evaluating alternatives and selecting
• projects
• Step 4
• Reviewing prior decisions

Ch 8
Ch 9
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Who is involved in the Capital Budgeting Process?

• Accounting
• Finance
• Engineering
• Corporate Planning
• Management
• Marketing

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Project Approval

• Size of investment proposal often determines who
  has authority to approve the project.

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Classify Investment Projects

• Growth opportunities
• Cost reduction opportunities
• Real Options
• Required to meet legal requirements
• Required to meet environmental, health safety
  standards
• Other, e.g. parking lots

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Estimating CFs

• On an incremental basis
• On an after-tax basis
• Include indirect effects
• Exclude sunk costs
• Opportunity costs of resources
• Typically ignore financing costs

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Normal vs. Non-normal Project

• Normal or Conventional Project
• Negative Cash outflow(s) followed by positive
  cash inflows
• Non-normal or Non-conventional Project
• Cash flow patterns with more than one sign change
  
• For instance, negative, positive, then negative

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Estimating the NINV

• Step 1 Cost plus installation and shipping
• Plus
• Step 2 Increases in net working capital
• Minus
• Step 3 Net proceeds from sale of existing
  assets
• Plus or minus
• Step 4 Taxes associated with the above
  sale
• Equals
• NINV (Net Investment)

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• The NINV for a multiple-period investment is the
  PV of the series of outlays discounted at the
  firms cost of capital

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Computing Net Cash Flows
Bottom-up Method

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Computing NCFs
NCF ( R - O)(1-T) T Dep - NWC
Tax Shield Method

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Calculating Cash Flows

• Change in Revenue - R
• Less Change in Operating Costs - O
• Less Change in Depreciation - D
• Equals Change in Operating Earnings before Taxes
  - OEBT
• Less Taxes - T
• Equals Change in Operating Earnings after Taxes
  - EAT
• Plus Change in Depreciation - D
• Less Change in Net Working Capital - NWC
• Equals Net Cash Flows - NCF

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Depreciation for Tax Purposes

• Modified Cost Recovery System (MACRS)
• Assigns depreciable assets into property classes
• Under MACRS, the depreciable basis of an asset is
  usually equal to the purchase price plus
  installation and shipping charges.
• Please see Tables 8A-2 and 8A-3 on pages 301 and
  302 of your text.
• Straight Line Depreciation
• Cost / Estimated economic life (years)
• Recover any salvage
• Should Use half-year convention

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Tax Consequences at the End of a Projects Life
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Financing Charges

• Financing charges, such as interest charges are
  typically not considered in estimating a
  projects cash flow.
• Double Counting
• Investment Decision should be independent of
  Financing Decision
• Weighted Average Cost of Capital Method
• Equity Residual Method
• Used in Mergers and Acquisitions
• Used in Real Estate

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Ethical IssuesBiased CF Estimates

• Overestimate the revenues
• Compensation of managers may be tied to job
  responsibilities
• Underestimate the costs
• Reduce CF estimates to a level below the most
  likely outcome

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Capital Budgeting and Cash Flow Analysis

• Capital Expenditure Decisions
• Cost of Capital
• Capital Budgeting Process
• Net Investment (NINV)
• Net Cash Flows
• Depreciation for Tax Purposes
• Ethical Issues