HFT 4464

1. HFT 4464 Chapter 9 Introduction to Capital Budgeting

2. Chapter 9 Introduction • Capital budgeting is the decision-making process used in the acquisition of long-term physical assets. • Traditional capital budgeting projects include decisions to invest in the following: • A new hotel • A casino expansion • Addition of a bar to a restaurant • Replacement of a sprinkler system at a hotel

3. Chapter 9 Introduction • Capital budgeting decisions are crucial to a firm’s long-term financial health. • Successful capital budgeting projects usually generate a positive cash flow for a long period of time. • Unsuccessful capital budgeting projects do not return sufficient cash flow to justify the investment. Such projects usually continue to generate losses or are liquidated for a large one-time loss. • Capital budgeting decisions set a firm’s future course by determining what services will be offered, how they will be offered, and where they will be offered.

4. Classifying Capital Budgeting Projects • The purpose of a project may be to: • Grow the firm causing future sales, profits, and cash flows to increase; includes typical expansion projects. • Reduce the firm’s future operating costs causing future profits and cash flows to increase; examples include new, more efficient air conditioners or new kitchen equipment requiring less maintenance. • Meet legal requirements or satisfy ethical considerations; examples include fire alarm and fire suppression systems.

5. Classifying Capital Budgeting Projects • Independent versus mutually exclusive projects. • An independent project requires a stand-alone decision. The project is analyzed in isolation and not compared to other projects. An example is a proposal to add a new 200-room tower to a hotel.

6. Classifying Capital Budgeting Projects • Mutually exclusive projects require a choice between two or more projects. For example, a decision to replace the air conditioning system with brand x, brand y, or brand z is a mutually exclusive decision. If you decide to invest in a new air conditioning system by brand x, then brands y and z have been excluded!

7. Project Cash Flows • Estimating a project’s impact on a firm’s future cash flows is a crucial part of the investment decision. Some basic principles need to be followed when estimating a project’s cash flows: • An incremental basis (the change in cash flow) • An after-tax basis • Indirect effects should be included (cannibalism / new ) • Costs should be measured as opportunity costs and not based upon historical or sunk costs

8. Project Cash Flows • The capital budgeting decision is essentially based upon a cost/benefit analysis. • The cost of a project is called the net investment (aka initial outlay). • The benefits from a project are the future cash flows generated. We call these the net cash flows.

9. Net Investment • The net cash outflows required to ready a project for its basic operation; the net investment includes: • Cost of any assets • + Delivery costs • + Installation costs • + Any required increase in net working capital • – After-tax salvage value from replaced assets

10. Net Cash Flows • These are the future cash flows generated from a project once it commences operation. The net cash flows are expected to continue throughout the project’s economic life. • The net cash flow for each year is: •  Earnings before taxes x (1 – t) • +  Depreciation • -  Net working capital

11. Net Cash Flows • And  Earnings before taxes is estimated by: •  Sales revenue • –  Operating expenses • –  Depreciation • Interest expense is generally not included in the net cash flows since it will be taken into account later through the firm’s required rate of return.

12. Terminal Non-operating Cash Flow • These are special one-time cash flows that only occur at the end of a project’s life. They are added to a project’s last net cash flow. They include: • After-tax salvage value of the project’s assets • Return of any increased net working capital • NCF = Cash received – ((Cash Received – Remaining Basis ) x Tax Rate)

13. Computation of After-Tax Salvage Values • Taxes owed on salvage value depend upon the salvage price relative to the asset’s book value. • As asset’s book value is the asset’s original acquisition cost minus all depreciation taken on the asset (accumulated depreciation).

14. Computation of After-Tax Salvage Values • If an asset is sold for its book value then no taxes are owed. • If an asset is sold for more than book value, then taxes are owed on this excess. • If an asset is sold for less than book value, then taxes are reduced. The loss acts as a tax shelter, reducing taxes by an amount equal to the firm’s marginal tax rate times the deficit.

15. Depreciation • The depreciation actually affecting cash flow is MACRS depreciation used for taxes. • MACRS depreciation varies by type of asset but always depreciates to a zero value, not an estimated salvage value. • Here we will simplify by assuming straight-line depreciation to a zero value.

16. Depreciation • Depreciation shelters income from taxes. • Thus, greater depreciation reduces taxes. • Depreciation is not an out-of-pocket expense. • Thus an increase in depreciation will reduce profit but increase cash flow. • Cost Segregation topic

17. Summary of Chapter 9 Topics • The significance of good capital budgeting decisions to a firm’s long-term financial health • Projects can be classified according to: • Purpose • Independent versus mutually exclusive decisions

18. Summary of Chapter 9 Topics • The cash flows associated with a project are crucial to the investment decision. They include: • Net investment • Net cash flows • Terminal nonoperating cash flows

19. Homework • Problems: • 1,2,3,4 & 5