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Capital Budgeting. Process of identifying, evaluating, and selecting capital projects Capital projects involve the purchase of a long-term (fixed) asset Part of the “Investment Decision” from Chapter 1 – What assets should the firm own?. Types of Projects. Replacement of existing assets

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Capital Budgeting

  • Process of identifying, evaluating, and selecting capital projects

  • Capital projects involve the purchase of a long-term (fixed) asset

  • Part of the “Investment Decision” from Chapter 1 – What assets should the firm own?

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Types of Projects

  • Replacement of existing assets

  • Expansion of existing products or services

  • Addition of new product lines or services

  • Government mandated projects

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Steps in Capital Budgeting Process

  • 1) Generate ideas for projects

  • 2) Estimate incremental cash flows for proposed project

  • 3) Evaluate riskiness of incremental cash flows

  • 4) Select projects that will increase shareholder wealth

  • 5) Monitor outcome of accepted projects

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Step 2: Estimating Incremental Cash Flows

  • Incremental means that we only look at those cash flows that will CHANGE if we proceed with the project

  • Analyze the proposal as if the company is going to do the project – figure out which outflows and inflows will be affected and by how much

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Types of Incremental Cash Flows

  • 1. Net Investment Cash Outflow (NICO) = initial cash outlay at start of project

  • 2. Operating Cash Inflows (OCFs) = annual cash flows from using the new assets

  • 3. Disposal Cash Flow (DCF) = special cash flows associated with ending the project

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Watch Out For …

  • Sunk Costs – (money has already been spent) - NOT incremental

  • Opportunity Costs – (is there an alternate use for an asset?) - ARE incremental

  • Side Effects – (Acceptance of project has effect on existing project) - ARE incremental

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Net Investment Cash Outflow (NICO)

  • Initial cash outlay at beginning of project

  • Cash outlay obviously based on new asset’s cost, but other factors must be considered as well

  • Look for 6 possible items to include in NICO estimate

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NICO Checklist

  • 1. Cost of new asset(s) = outflow

  • 2. Extra charges (shipping, handling, freight, delivery, installation, modification, etc.) = outflow

  • Note that for IRS purposes, the extra charges are included in the new asset’s depreciable base

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NICO Checklist continued

  • 3. Investment Tax Credit – sometimes an asset purchase will be eligible for a federal income tax credit; take % x cost to get amount of credit; credit = inflow

  • 4. Change in Net Working Capital – NWC = CA – CL; sometimes the purchase of a long-term asset results in a change in CA or CL

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NICO Checklist continued

  • 4. cont. Suppose purchase of a new asset causes an increase or a decrease in spare parts inventory (a CA). This change wouldn’t have happened if we hadn’t bought the new long-term asset.

  • Any changes in CA or CL resulting from the purchase of a new long-term asset must be considered – it’s incremental!

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NICO Checklist Continued

  • 4. cont. Look for changes in CA and/or in CL. Net out the changes using NWC = CA – CL.

  • An increase in NWC is a cash outflow.

  • A decrease in NWC is a cash inflow.

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NICO Checklist Continued

  • 5. Proceeds from sale (disposal) of old asset = inflow

  • 6. Any time depreciable asset is sold, must look at tax effects (do you owe taxes on sale, create a tax savings with the sale, or have no tax effect from the sale?)

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Tax Effects of Sale (Disposal) of a Depreciable Asset

  • Compare Market Value (MV) to Book Value (BV)

  • Book Value = original cost still on books; unclaimed depreciation

  • If MV > BV, gain on disposal; must pay taxes on gain.

  • Taxes owed = gain x tax rate (outflow)

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Tax Effects continued

  • If MV < BV, loss on disposal. Do not pay taxes on losses. Loss creates tax savings.

  • Tax savings = Loss x tax rate (Inflow)

  • If MV = BV, no gain or loss on disposal. (No tax effect)

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Summary of NICO

  • From your list of 6 possible items, net the outflows against the inflows.

  • NOTE that not all problems will have all 6 times – some just have one or two!

  • You should have one final outflow estimate of what it costs to get the project started

  • Save this number to use in project selection analysis

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Operating Cash Inflows (OCFs)

  • Net the proposed project’s revenues and expenses for each year of the project’s useful life using the following equation:

  • OCF = (S – TVC – TFC – D)(1 – T) + D

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Definitions of Terms in OCF Equation

  • S = Sales = Price per unit x # units

  • TVC = Total Variable Costs = VC per unit x # units

  • TFC = Total Fixed Costs = Lump Sum

  • D = Depreciation (see next slide)

  • T = Marginal Tax Rate

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  • Follow IRS rules for depreciating long-term (fixed) assets

  • IRS-approved method = Modified Accelerated Cost Recovery System (MACRS)

  • To calculate annual depreciation expense, determine depreciable base and class life

  • Look in text p. 218 at MACRS table for % to apply against base

  • D = Base x %

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Summary of OCFs

  • Calculate the OCF equation for each year that the new asset is being used

  • Keep a list of all of the OCFs – don’t add them all together (they occur in different time periods!)

  • Save OCFs to use in project selection analysis

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Disposal Cash Flow (DCF)

  • 1. Proceeds from disposal of “new” asset (now old) = inflow

  • 2. Tax effects of disposal of “new” asset (Follow rules listed earlier in NICO section) (outflow or inflow)

  • 3. Recovery of Net Working Capital (NWC): If “new” asset is no longer being used, CA and CL are assumed to revert to their pre-project levels.

  • Increase in NWC under NICO = inflow for DCF

  • Decrease in NWC under NICO = outflow for DCF

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Summary of DCF

  • Net outflows and inflows to get one disposal cash flow

  • This disposal cash flow will be added to the final year’s OCF when we get to project selection analysis.

  • 2 cash flows in last year of project: one from using it during the year and one from stopping it at the end of the year