Capital Budgeting

1. 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?

2. Types of Projects • Replacement of existing assets • Expansion of existing products or services • Addition of new product lines or services • Government mandated projects

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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!

11. 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.

12. 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?)

13. 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)

14. 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)

15. 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

16. 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

17. 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

18. Depreciation • 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 %

19. 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

20. 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

21. 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