FM10e - ch10 - 1 - Trim Cash Flows and Other Topics in Capital Budgeting

Chapter 10 - Cash Flows and
Other Topics in Capital Budgeting
Capital Budgeting: The process of planning

for purchases of long-term assets.
For example: Our firm must decide whether
to purchase a new plastic molding machine
for $127,000. How do we decide?
Will the machine be profitable?
Will our firm earn a high rate of return on
the investment?
The relevant project information follows:
The cost of the new machine is $127,000.

Installation will cost $20,000.
$4,000 in net working capital will be needed at
the time of installation.

The project will increase revenues by $85,000 per
year, but operating costs will increase by 35% of
the revenue increase.
Simplified straight line depreciation is used.
Class life is 5 years, and the firm is planning to
keep the project for 5 years.
Salvage value at the end of year 5 will be $50,000.
14% cost of capital; 34% marginal tax rate.
Capital Budgeting Steps

1) Evaluate Cash Flows
Look at all incremental cash flows
occurring as a result of the project.
Initial outlay
Differential Cash Flows over the life
of the project (also referred to as
annual cash flows).
Terminal Cash Flows

...

Initial
outlay
...

Initial
outlay
Annual Cash Flows
...

Terminal
Cash flow
Initial
outlay
Annual Cash Flows
...

2) Evaluate the Risk of the Project
Well get to this in the next chapter.
For now, well assume that the risk of the
project is the same as the risk of the
overall firm.
If we do this, we can use the firms cost of
capital as the discount rate for capital
investment projects.

3) Accept or Reject the Project
Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at
time 0?
(Purchase price of the asset)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

time 0?
(127,000)
+ (shipping and installation costs)
(Depreciable asset)
Net Initial Outlay

time 0?
(127,000)
+ ( 20,000)
(Depreciable asset)
Net Initial Outlay

time 0?
(127,000)
+ ( 20,000)
(147,000)
Net Initial Outlay

time 0?
(127,000)
+ (20,000)
(147,000)
+ (4,000)
Net Initial Outlay

time 0?
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+
0
Net Initial Outlay

time 0?
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+
0
($151,000)
Purchase price of asset

Shipping and installation
Depreciable asset
Net working capital
Proceeds from sale of old asset
Net initial outlay

time 0?
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+
0
($151,000)
Purchase price of asset

Shipping and installation
Depreciable asset
Net working capital
Proceeds from sale of old asset
Net initial outlay

b) Annual Cash Flows: What
incremental cash flows occur over the
life of the project?
For Each Year, Calculate:

Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
For Years 1 - 5:
Incremental revenue
- Incremental costs
Annual Cash Flow
For Years 1 - 5:
85,000
- Incremental costs
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
29,400
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
29,400
46,461 =
Revenue
Costs
Depreciation
EBT
Taxes
EAT
Depreciation reversal
Annual Cash Flow

c) Terminal Cash Flow: What is the cash
flow at the end of the projects life?
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow

50,000
Salvage value
Terminal Cash Flow
Tax Effects of Sale of Asset:

Salvage value = $50,000.
Book value = depreciable asset - total
amount depreciated.
Book value = $147,000 - $147,000
= $0.
Capital gain = SV - BV
= 50,000 - 0 = $50,000.
Tax payment = 50,000 x .34 = ($17,000).

50,000
(17,000)
Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow

50,000
(17,000)
4,000
Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow

50,000
(17,000)
4,000
37,000
Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow
Project NPV:
CF(0) = -151,000.
CF(1 - 4) = 46,461.
CF(5) = 46,461 + 37,000 = 83,461.
Discount rate = 14%.
NPV = $27,721.
We would accept the project.
Capital Rationing
Suppose that you have evaluated

five capital investment projects
for your company.
Suppose that the VP of Finance
has given you a limited capital
budget.
How do you decide which
projects to select?
Capital Rationing
You could rank the projects by IRR:
Capital Rationing

IRR
25%
20%
15%
10%
5%
1
$
Capital Rationing

IRR
25%
20%
15%
10%
5%
2
$
Capital Rationing

IRR
25%
20%
15%
10%
5%
3
$
Capital Rationing

IRR
25%
20%
15%
10%
5%
4
$
Capital Rationing

IRR
25%
20%
15%
10%
5%
5
$
Capital Rationing

IRR
Our budget is limited

so we accept only
projects 1, 2, and 3.
25%
20%
15%
10%
5%
4
$X
5
$
Capital Rationing

IRR
Our budget is limited

so we accept only
projects 1, 2, and 3.
25%
20%
15%
10%
5%
3
$X
Capital Rationing
Ranking projects by IRR is not

always the best way to deal with a
limited capital budget.
Its better to pick the largest NPVs.
Lets try ranking projects by NPV.
Problems with Project Ranking

1) Mutually exclusive projects of unequal
size (the size disparity problem)
The NPV decision may not agree with
IRR or PI.
Solution: select the project with the
largest NPV.
Size Disparity Example

Project A
year cash flow
0
(135,000)
1
60,000
2
60,000
3
60,000
required return = 12%
IRR = 15.89%
NPV = $9,110
PI = 1.07

Project A
year cash flow
0
(135,000)
1
60,000
2
60,000
3
60,000
IRR = 15.89%
NPV = $9,110
PI = 1.07
Project B
year cash flow
0
(30,000)
1
15,000
2
15,000
3
15,000
IRR = 23.38%
NPV = $6,027
PI = 1.20

Project A
year cash flow
0
(135,000)
1
60,000
2
60,000
3
60,000
IRR = 15.89%
NPV = $9,110
PI = 1.07
Project B
year cash flow
0
(30,000)
1
15,000
2
15,000
3
15,000
IRR = 23.38%
NPV = $6,027
PI = 1.20
Problems with Project Ranking

2) The time disparity problem with mutually
exclusive projects.
NPV and PI assume cash flows are
reinvested at the required rate of return for
the project.
IRR assumes cash flows are reinvested at
the IRR.
The NPV or PI decision may not agree with
the IRR.
Solution: select the largest NPV.
Time Disparity Example

Project A
year cash flow
0
(48,000)
1
1,200
2
2,400
3
39,000
4
42,000
IRR = 18.10%
NPV = $9,436
PI = 1.20

Project A
year cash flow
0
(48,000)
1
1,200
2
2,400
3
39,000
4
42,000
Project B
year cash flow
0
(46,500)
1
36,500
2
24,000
3
2,400
4
2,400
IRR = 18.10%
NPV = $9,436
PI = 1.20
IRR = 25.51%
NPV = $8,455
PI = 1.18

Project A
year cash flow
0
(48,000)
1
1,200
2
2,400
3
39,000
4
42,000
Project B
year cash flow
0
(46,500)
1
36,500
2
24,000
3
2,400
4
2,400
IRR = 18.10%
NPV = $9,436
PI = 1.20
IRR = 25.51%
NPV = $8,455
PI = 1.18
Mutually Exclusive Investments

with Unequal Lives
Suppose our firm is planning to expand

and we have to select one of two machines.
They differ in terms of economic life and
capacity.
How do we decide which machine to select?
The after-tax cash flows are:

Year
Machine 1
Machine 2
0
(45,000)
(45,000)
1
20,000
12,000
2
20,000
12,000
3
20,000
12,000
4
12,000
5
12,000
6
12,000
Assume a required return of 14%.
Step 1: Calculate NPV

NPV1 = $1,433
NPV2 = $1,664
So, does this mean #2 is better?
No! The two NPVs cant be
compared!
Step 2: Equivalent Annual

Annuity (EAA) method
If we assume that each project will be

replaced an infinite number of times in the
future, we can convert each NPV to an
annuity.
The projects EAAs can be compared to
determine which is the best project!
EAA: Simply annuitize the NPV over the
projects life.
EAA with your calculator:
Simply spread the NPV over the life

of the project
Machine 1: PV = 1433, N = 3, I = 14,

solve: PMT = -617.24.
Machine 2: PV = 1664, N = 6, I = 14,

solve: PMT = -427.91.
EAA1 = $617
EAA2 = $428
This tells us that:
NPV1 = annuity of $617 per year.
NPV2 = annuity of $428 per year.
So, weve reduced a problem with
different time horizons to a couple of
annuities.
Decision Rule: Select the highest EAA.
We would choose machine #1.
Step 3: Convert back to NPV
Assuming infinite replacement, the

EAAs are actually perpetuities. Get the
PV by dividing the EAA by the required
rate of return.

rate of return.
NPV 1 = 617/.14 = $4,407

rate of return.
NPV 1 = 617/.14 = $4,407

NPV 2 = 428/.14 = $3,057
Assuming infinite replacement, the EAAs

are actually perpetuities. Get the PV by
dividing the EAA by the required rate of
return.
NPV 1 = 617/.14 = $4,407
NPV 2 = 428/.14 = $3,057
This doesnt change the answer, of course;

it just converts EAA to an NPV that can be
compared.
Practice Problems:
Cash Flows & Other Topics
in Capital Budgeting
Project Information:
Problem 1a
Cost of equipment = $400,000.
Shipping & installation will be $20,000.
$25,000 in net working capital required at setup.
3-year project life, 5-year class life.
Simplified straight line depreciation.
Revenues will increase by $220,000 per year.
Defects costs will fall by $10,000 per year.
Operating costs will rise by $30,000 per year.
Salvage value after year 3 is $200,000.
Cost of capital = 12%, marginal tax rate = 34%.
Problem 1a
Initial Outlay:
(400,000)
+ ( 20,000)
(420,000)
+ ( 25,000)
($445,000)
Cost of asset
Shipping & installation
Depreciable asset
Investment in NWC
Net Initial Outlay
For Years 1 - 3:
220,000
10,000
(30,000)
(84,000)
116,000
(39,440)
76,560
84,000
160,560 =
Problem 1a
Increased revenue
Decreased defects
Increased operating costs
Increased depreciation
EBT
Taxes (34%)
EAT
Annual Cash Flow
Problem 1a
Terminal Cash Flow:
Salvage value
Terminal Cash Flow
Terminal Cash Flow:
Problem 1a

amount depreciated.
Book value = $168,000.
Capital gain = SV - BV = $32,000.
Tax payment = 32,000 x .34 = ($10,880).
Problem 1a
Terminal Cash Flow:
200,000
(10,880)
25,000
214,120
Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow
Problem 1a Solution
NPV and IRR:
CF(0) = -445,000
CF(1 ), (2), = 160,560
CF(3 ) = 160,560 + 214,120 = 374,680
Discount rate = 12%
IRR = 22.1%
NPV = $93,044. Accept the project!
Problem 1b
Project Information:
For the same project, suppose we
can only get $100,000 for the old
equipment after year 3, due to
rapidly changing technology.
Calculate the IRR and NPV for the
project.
Is it still acceptable?
Problem 1b
Terminal Cash Flow:
Salvage value
Terminal Cash Flow
Terminal Cash Flow:
Problem 1b

amount depreciated.
Book value = $168,000.
Capital loss = SV - BV = ($68,000).
Tax refund = 68,000 x .34 = $23,120.
Problem 1b
Terminal Cash Flow:
100,000
23,120
25,000
148,120
Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow
Problem 1b Solution
NPV and IRR:
CF(0) = -445,000.
CF(1), (2) = 160,560.
CF(3) = 160,560 + 148,120 = 308,680.
IRR = 17.3%.
NPV = $46,067. Accept the project!
Automation Project:
Problem 2
Cost of equipment = $550,000.
$15,000 in net working capital required at setup.
Current operating expenses are $640,000 per yr.
New operating expenses will be $400,000 per yr.
Already paid consultant $25,000 for analysis.
Problem 2
Initial Outlay:
+
+
(550,000)
(25,000)
(575,000)
(15,000)
(590,000)
Cost of new machine

Shipping & installation
Depreciable asset
NWC investment
Net Initial Outlay
For Years 1 - 5:
240,000
(115,000)
125,000
(42,500)
82,500
115,000
197,500 =
Problem 2
Cost decrease
Depreciation increase
EBIT
Taxes (34%)
EAT
Annual Cash Flow
For Years 6 - 8:
240,000
(
0)
240,000
(81,600)
158,400
0
158,400 =
Problem 2
Cost decrease
Depreciation increase
EBIT
Taxes (34%)
EAT
Annual Cash Flow
Problem 2
Terminal Cash Flow:
40,000
(13,600)
15,000
41,400
Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow
Problem 2 Solution
NPV and IRR:
CF(0) = -590,000.
CF(1 - 5) = 197,500.
CF(6 - 7) = 158,400.
CF(10) = 158,400 + 41,400 = 199,800.
IRR = 28.13%
NPV = $293,543.
We would accept the project!
Problem 3
Replacement Project:
Old Asset (5 years old):
Cost of equipment = $1,125,000.
Current salvage value is $400,000.
Cost of capital = 14%, marginal tax
rate = 35%.
Replacement Project:
Problem 3
New Asset:
Cost of equipment = $1,750,000.
$68,000 investment in net working capital.
Will increase sales by $285,000 per year.
Operating expenses will fall by $100,000 per year.
Already paid $15,000 for training program.
Problem 3: Sell the Old Asset

amount depreciated.
Book value = $1,125,000 - $562,500
= $562,500.
Capital gain = SV - BV
= 400,000 - 562,500 = ($162,500).
Tax refund = 162,500 x .35 = $56,875.
Initial Outlay:
Problem 3
(1,750,000) Cost of new machine

+ ( 56,000) Shipping & installation
(1,806,000) Depreciable asset
+ ( 68,000) NWC investment
+ 456,875 After-tax proceeds (sold
old machine)
(1,417,125) Net Initial Outlay
For Years 1 - 5:
385,000
(248,700)
136,300
(47,705)
88,595
248,700
337,295 =
Problem 3
Increased sales & cost savings

Extra depreciation
EBT
Taxes (35%)
EAT
Differential Cash Flow
Problem 3
Terminal Cash Flow:
500,000
(175,000)
68,000
393,000
Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow
Problem 3 Solution
NPV and IRR:
CF(0) = -1,417,125.
CF(1 - 4) = 337,295.
CF(5) = 337,295 + 393,000 = 730,295.
NPV = (55,052.07).
IRR = 12.55%.
We would not accept the project!

FM10e - ch10 - 1 - Trim Cash Flows and Other Topics in Capital Budgeting

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Chapter 10 - Cash Flows and

Other Topics in Capital Budgeting

Capital Budgeting: The process of planning

The cost of the new machine is $127,000.

the time of installation.

Capital Budgeting Steps

Capital Budgeting Steps

Capital Budgeting Steps

Capital Budgeting Steps

Annual Cash Flows

Capital Budgeting Steps

Annual Cash Flows

Capital Budgeting Steps

Capital Budgeting Steps

Step 1: Evaluate Cash Flows

Step 1: Evaluate Cash Flows

Step 1: Evaluate Cash Flows

Step 1: Evaluate Cash Flows

Step 1: Evaluate Cash Flows

Step 1: Evaluate Cash Flows

Step 1: Evaluate Cash Flows

Purchase price of asset

Step 1: Evaluate Cash Flows

Purchase price of asset

Step 1: Evaluate Cash Flows

For Each Year, Calculate:

Step 1: Evaluate Cash Flows

Step 1: Evaluate Cash Flows

Tax Effects of Sale of Asset:

Step 1: Evaluate Cash Flows

Step 1: Evaluate Cash Flows

Step 1: Evaluate Cash Flows

Suppose that you have evaluated

You could rank the projects by IRR:

You could rank the projects by IRR:

You could rank the projects by IRR:

You could rank the projects by IRR:

You could rank the projects by IRR:

You could rank the projects by IRR:

You could rank the projects by IRR:

Our budget is limited

You could rank the projects by IRR:

Our budget is limited

Ranking projects by IRR is not

Problems with Project Ranking

Size Disparity Example

Size Disparity Example

Size Disparity Example

Problems with Project Ranking

Time Disparity Example

Time Disparity Example

Time Disparity Example

Mutually Exclusive Investments

Suppose our firm is planning to expand

The after-tax cash flows are:

Step 1: Calculate NPV

Step 2: Equivalent Annual

If we assume that each project will be

EAA with your calculator:

Simply spread the NPV over the life

Machine 1: PV = 1433, N = 3, I = 14,

Machine 2: PV = 1664, N = 6, I = 14,