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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
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
Types of Projects
  • Replacement of existing assets
  • Expansion of existing products or services
  • Addition of new product lines or services
  • Government mandated projects
steps in capital budgeting process
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
step 2 estimating incremental cash flows
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
types of incremental cash flows
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
watch out for
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
net investment cash outflow nico
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
nico checklist
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
nico checklist continued
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
nico checklist continued10
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!
nico checklist continued11
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.
nico checklist continued12
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?)
tax effects of sale disposal of a depreciable asset
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)
tax effects continued
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)
summary of nico
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
operating cash inflows ocfs
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
definitions of terms in ocf equation
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
  • 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 %
summary of ocfs
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
disposal cash flow dcf
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
summary of dcf
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