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CH 10 Making Capital Budgeting Decision

CH 10 Making Capital Budgeting Decision. Capital Budgeting : The process of planning for purchases of LT assets. For example : Our firm must decide whether to purchase a new plastic molding machine for $127,000 . How do we decide? Will the machine be profitable ?

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CH 10 Making Capital Budgeting Decision

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  1. CH 10Making Capital Budgeting Decision

  2. Capital Budgeting: The process of planning for purchases of LT assets. For example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? • Will the machine be profitable? • Will our firm earn a high rate of return on the investment? • The relevant project information follows:

  3. The cost of the new machine is $127,000. • Installation will cost $20,000. • $4,000 in net working capital will be needed at the time of installation. • The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. • Simplified straight line depreciation is used. • Class life is 5 years, and the firm is planning to keep the project for 5 years. • Salvage value at the end of year 5 will be $50,000. • 14% cost of capital; 34% marginal tax rate.

  4. Capital Budgeting Steps 1) Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project. • Initial outlay • Differential Cash Flowsover the life of the project (also referred to as annual cash flows). • Terminal Cash Flows

  5. . . . 0 1 2 3 4 5 6 n Capital Budgeting Steps 1) Evaluate Cash Flows Terminal Cash flow Initial outlay Annual Cash Flows

  6. Capital Budgeting Steps 2)Evaluate the Risk of the Project • For now, we’ll assume that the risk of the project is the same as the risk of the overall firm. • Because of the above assumption, we can use the firm’s cost of capital as the discount rate for capital investment projects. (same risk = same rate)

  7. Capital Budgeting Steps • Accept or Reject the Project • Accept or reject based on NPV calculation D-O-N-E

  8. Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (Purchase price of the asset) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

  9. Step 1: Evaluate Cash Flows • a) Initial Outlay: What is the cash flow at “time 0?” (127,000) Purchase price of asset + (20,000) Shipping and installation (147,000) Depreciable asset + (4,000) Net working capital + 0 Proceeds from sale of old asset ($151,000) Net initial outlay

  10. Step 1: Evaluate Cash Flows b) Annual Cash Flows: What incremental cash flows occur over the life of the project?

  11. For Each Year, Calculate: Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

  12. For Years 1 - 5: 85,000 Revenue (29,750) Costs (29,400) Depreciation 25,850 EBT (8,789) Taxes 17,061 EAT 29,400 Depreciation reversal 46,461 = Annual Cash Flow

  13. Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

  14. Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

  15. Tax Effects of Sale of Asset: • Salvage value = $50,000. • Book value = depreciable asset - total amount depreciated. • Book value = $147,000 - $147,000 = $0. • Capital gain = SV - BV = 50,000 - 0 = $50,000. • Tax payment = 50,000 x .34 = ($17,000).

  16. Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain Recapture of NWC Terminal Cash Flow

  17. Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain 4,000Recapture of NWC Terminal Cash Flow

  18. Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain 4,000 Recapture of NWC 37,000 Terminal Cash Flow

  19. Project NPV: • CF(0) = -151,000. • CF(1 - 4) = 46,461. • CF(5) = 46,461 + 37,000 = 83,461. • Discount rate = 14%. • NPV = $27,721. • We would acceptthe project.

  20. Practice Problems:Cash Flows & Other Topics in Capital Budgeting

  21. Problem 1a Project Information: • Cost of equipment = $400,000. • Shipping & installation will be $20,000. • $25,000 in net working capital required at setup. • 3-year project life, 5-year class life. • Simplified straight line depreciation. • Revenues will increase by $220,000 per year. • Defects costs will fall by $10,000 per year. • Operating costs will rise by $30,000 per year. • Salvage value after year 3 is $200,000. • Cost of capital = 12%, marginal tax rate = 34%.

  22. Problem 1b Project Information: • For the same project, suppose we can only get $100,000 for the old equipment after year 3, due to rapidly changing technology. • Calculate the IRR and NPV for the project. • Is it still acceptable?

  23. Problem 2 Automation Project: • Cost of equipment = $550,000. • Shipping & installation will be $25,000. • $15,000 in net working capital required at setup. • 8-year project life, 5-year class life. • Simplified straight line depreciation. • Current operating expenses are $640,000 per yr. • New operating expenses will be $400,000 per yr. • Already paid consultant $25,000 for analysis. • Salvage value after year 8 is $40,000. • Cost of capital = 14%, marginal tax rate = 34%.

  24. Problem 3 Replacement Project: Old Asset (5 years old): • Cost of equipment = $1,125,000. • 10-year project life, 10-year class life. • Simplified straight line depreciation. • Current salvage value is $400,000. • Cost of capital = 14%, marginal tax rate = 35%.

  25. Problem 3 Replacement Project: New Asset: • Cost of equipment = $1,750,000. • Shipping & installation will be $56,000. • $68,000 investment in net working capital. • 5-year project life, 5-year class life. • Simplified straight line depreciation. • Will increase sales by $285,000 per year. • Operating expenses will fall by $100,000 per year. • Already paid $15,000 for training program. • Salvage value after year 5 is $500,000. • Cost of capital = 14%, marginal tax rate = 34%.

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