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The Capital
Budgeting Process
The Capital
Budgeting Process
Reevaluate implemented
investment projects continually and
perform postaudits for completed
projects.
Classification of Investment
Project Proposals
1. New products or expansion of existing
products
2. Replacement of existing equipment or
buildings
3. Research and development
4. Exploration
5. Other (e.g., safety or pollution related)
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Estimating After-Tax
Incremental Cash Flows
Basic characteristics of relevant
project flows
After-tax flows
Incremental flows
Estimating After-Tax
Incremental Cash Flows
Principles that must be adhered to
in the estimation
Tax Considerations
and Depreciation
Depreciable Basis
In tax accounting, the fully installed
cost of an asset. This is the amount
that, by law, may be written off over
time for tax purposes.
Depreciable Basis =
Capitalized Expenditures
Capitalized Expenditures are
expenditures that may provide benefits
into the future and therefore are treated
as capital outlays and not as expenses of
the period in which they were incurred.
Sale or Disposal of a
Depreciable Asset
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Interim incremental net cash flows -those net cash flows occurring after the
initial cash investment but not including
the final periods cash flow.
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a)
b)
c)
d)
e)
f)
g)
Terminal-Year Incremental
Cash Flows
a)
b)
c)
d)
e)
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Example of an Asset
Expansion Project
XL Dhaba is considering the purchase of a new
juice extracting machine. The machine will cost
110,0000 plus 10000 for shipping and installation.
NWC will rise by 15,000. Company forecasts that
revenues will increase by 110,000 for each of the
next 4 years and will then be sold (scrapped) for
10,000 at the end of the fourth year, when the life of
the machine ends. Operating costs will rise by
70,000 for each of the next four years. XL Dhaba is
in the 30% tax bracket.
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110,000
10,000
15,000
+
0 (not a replacement)
- (+)
0 (not a replacement)
=
-135,000
Depreciation Calculation
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Year 1
Year 2
Year 3
40,000
40,000
40,000
Year 4
40,000
b)
25,000
25,000
25,000
25,000
c)
15,000
15,000
15,000
15,000
d)
4,500
4,500
4,500
4,500
e)
11,500
11,500
11,500
11,500
f)
25,000
25,000
25,000
25,000
g)
36,500
36,500
36,500
36,500
Terminal-Year Incremental
Cash Flows
a)
36,500
b)
10,000
c)
d)
15,000
e)
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51,500
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Year 1
36,500
Year 2
Year 3
Year 4
36,500
36,500
51,500
Example of an Asset
Replacement Project
Let us assume that previous asset expansion project is
actually an asset replacement project. The original
basis of the machine was 50,000 and depreciated using
straight-line over five years (10,000 per year). The
machine has three years of depreciation and four years
of useful life remaining. XL Dhaba can sell the current
machine for 15,000. The new machine will not increase
revenues (remain at 110,000) but it decreases operating
expenses by 10,000 per year (old = 80,000). NWC will
rise to 20,000 from 5,000 (old).
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+
+
=
110,000
10,000
15,000
15,000 (sale of old asset)
4,500 <---- (tax savings from
loss on sale of
115,500
old asset)
Year 1
Year 2
25,000
25,000
10,000
10,000
Year 3
Year 4
25,000
25,000
10000
15,000
25,000
0
c)
15,000
15,000
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Year 1
Year 2
Year 3
Year 4
10,000
10,000
10,000
10,000
b)
15,000
15,000
15,000
25,000
c)
-5,000
-5000
-5000
-15,000
d)
-1,500
-1,500
-1,500
e)
-3,500
-3,500
f)
15,000
15,000
15,000
25,000
g)
11,500
11,500
11,500
13,500
-3,500
4,500
-11,500
Terminal-Year Incremental
Cash Flows
a)
13,500
10,000
Salvage Value.
b)
c)
d)
e)
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38,500
Terminal-year incremental
cash flow.
Year 1
36,500
Year 2
Year 3
Year 4
36,500
36,500
51,500
Asset Replacement
Year 0
-115,500
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Year 1
11,500
Year 2
11,500
Year 3
Year 4
11,500
38,500
Problem: 1(Purchase of a
New Asset)
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Problem: 2(Replacement
of an Old Asset)
Saha and Associates is considering the replacement of two machines that
are three years old with a new, more efficient machine. The old machines
could be sold currently for a total of Rs. 70000 in the secondary market,
but they would have zero salvage value if held to the end of their
remaining useful life. Their original depreciable basis totaled Rs. 300000.
They have a depreciated tax book value of 86400, and a remaining useful
life of eight years. The new machine can be purchased and installed for
Rs. 480000. It has a useful life of eight years, at the end of which a
salvage value of 40000 is expected. Due to greater efficiency, the new
machine is expected to result in incremental annual operating savings of
Rs. 100000. The companys corporate tax rate is 40 percent, and is a loss
occurs in any year on the project, it is assumed that the company can
offset the loss against other company income. What are the incremental
cash inflows over the eight years, and what is the incremental cash
outflow at time 0?
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