Contemporary Financial Management

1. Contemporary Financial Management Chapter 9: Capital Budgeting and Cash Flow Analysis

2. Introduction • This chapter discusses capital budgeting and capital expenditures • It deals with the financial management of the assets on a firm’s balance sheet

3. Capital Budgeting • The process of planning for purchases of assets whose useful lives are expected to continue beyond a year • Capital Expenditure • A cash outlay expected to generate a flow of future cash benefits for more than one year • Capital budgeting decisions can be among the most complex decisions facing management

4. Examples of Capital Expenditures • Expand an existing product line • Increase or decrease working capital • Refund an issue of debt • Leasing versus buying an asset • Mergers and acquisitions • Enter a new line of business • Repair versus replacing a machine • Advertising campaigns • Research and Development activities

5. Types of Investment Projects • Growth opportunities • Cost reduction opportunities • Required to meet legal requirements • Required to meet health and safety standards

6. How Projects are Classified • Independent • Acceptance or rejection has no effect on other projects • Mutually Exclusive • Acceptance of one automatically rejects the others (replace versus repair) • Contingent • Acceptance of one project is dependent upon the selection of another

7. Cost of Capital • Firm’s overall cost of funds, often referred to WACC or Weighted Average Cost of Capital • Equal to a weighted average of the investors’ required rates of return • The discount rate used to analysis capital budgeting proposals

8. Optimal Capital Budget • Expand output until marginal revenue equals marginal cost • Invest in the most profitable projects first • Continue accepting projects as long as the rate of return exceeds the marginal cost of capital (MCC)

9. The Optimal Capital Budget Rate Project Return Return exceeds cost MCC Cost exceeds return Fund these projects Funding available

10. Capital Budgeting Problems • All projects may not be known at one time • Changing markets, technology, and corporate strategies can quickly make current projects obsolete and make new ones profitable • Difficulty in determining the behavior of the marginal cost of capital (MCC) • Estimates of project cash flows have varying degrees of uncertainty

11. Capital Budgeting Process • Step 1: Generate proposals • Step 2: Estimate the cash flows • Step 3: Evaluate alternatives and select projects • Step 4: Review prior decisions

12. Estimating Cash Flows • Calculate only the incremental cash flows. • Measure on an after-tax basis. • All indirect effects should be included. • Sunk costs should not be considered • Value of resources should be measured in terms of their opportunity cost rather than their actual cost.

13. The Capital Budgeting Decision • The capital budgeting decision involves six steps: • Calculate initial investment • Calculate PV of the annual after-tax cashflows attributable to the new asset • Calculate PV of the tax-shield due to Capital Cost Allowance (CCA) • Calculate PV of salvage value • Calculate PV of the tax shield lost due to salvage • Calculate PV of any changes in working capital

14. 1: Calculate Initial Investment • The initial investment includes: • The cost of the new asset • Plus shipping & installation costs • Less any trade-in value received from an old asset • If expenditures on the new asset occur over a period of time, present value all costs back to time period zero

15. 2: PV of Annual After-Tax CFs T = corporate marginal tax rate k = WACC or discount rate t = year 1 through year N

16. 3: PV of Tax Shield due to CCA UCC = Undepreciated capital cost (cost - trade-in received) d = Capital cost allowance rate T = Corporate tax rate k = Firm’s cost of capital

17. 4: Calcuate PV of Salvage Salvage = the expected future salvage value k = the WACC or discount rate t = the number of years until the asset is salvaged

18. 5: PV of Tax Shield Lost from Salvage d = CCA rate T = Corporate tax rate k = WACC or discount rate t = number of years

19. 6: PV of Change in Working Capital or Working Capital = Current assets - current liabilities  = Increase in working capital  = Decrease in working capital

20. Capital Budgeting: Example • Alki Dyes Ltd. buys a new tank for $18,000, including installation. The estimated salvage value at the end of its 3-year useful life is $1,000. CCA is charged at a 50% rate. The tank is expected to increase the firm’s pre-tax cash flows by $10,000/year for the three years of useful life. Working capital is expected to increase by $1,000 at the end of the first year. The firm’s tax rate and WACC are 46% and 14% respectively. What is the NPV of the new investment?

21. Step 1: Initial investment Cash flow from tank purchase: -$18,000 Step 2: PV of annual cash flows Capital Budgeting: Solution

22. Capital Budgeting: Solution Step 3: PV of tax-shield due to CCA

23. Capital Budgeting: Solution Step 4: PV of salvage

24. Capital Budgeting: Solution Step 5: PV of the tax-shield lost due to salvage

25. Capital Budgeting: Solution Step 6: PV of the change in Working Capital

26. Step 1: Step 2: Step 3: Step 4: Step 5: Step 6: NPV -$18,000.00 +$12,536.81 +$6,071.55 +$674.97 -$242.57 -$877.19 +$163.57 Capital Budgeting: Solution

27. Ethical Issues: Biased CF Estimates • The outcome of any capital budgeting exercise is only as good as the estimates used as inputs. Problems may arise from: • Overestimated revenues • Underestimated costs • Unrealistic salvage values • Ignoring necessary changes in working capital

28. Major Points • Firms make investment decisions using a capital budgeting framework. • The capital budgeting process captures all of the incremental costs and benefits of undertaking a project. • If capital is unlimited, the firm will accept all positive NPV projects and reject all negative NPV projects.