Capital Budgeting and

Estimating Cash Flows

What is Capital Budgeting?

The process of identifying,
analyzing, and selecting
investment projects whose
returns (cash flows) are
expected to extend beyond
one year.
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The Capital
Budgeting Process

Generate investment proposals

consistent with the firms strategic
objectives.

Estimate after-tax incremental

operating cash flows for the
investment projects.

Evaluate project incremental cash

flows.

The Capital
Budgeting Process

Select projects based on a valuemaximizing acceptance criterion.

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

Cash (not accounting income) flows

Operating (not financing) flows

After-tax flows

Incremental flows

Estimating After-Tax
Incremental Cash Flows
Principles that must be adhered to
in the estimation

Ignore sunk costs

Include opportunity costs

Include project-driven changes in

working capital net of spontaneous
changes in current liabilities

Include effects of inflation

Tax Considerations
and Depreciation

Depreciation represents the systematic

allocation of the cost of a capital asset
over a period of time for financial
reporting purposes, tax purposes, or
both.
Generally, profitable firms prefer to use
an accelerated method for tax reporting
purposes.

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 =

Cost of Asset + Capitalized

Expenditures
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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.

Examples: Shipping and installation

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Sale or Disposal of a
Depreciable Asset

11

Generally, the sale of a capital asset (as

defined by the IT Dept) generates a
capital gain (asset sells for more than
book value) or capital loss (asset sells for
less than book value).

Often historically, capital gains

income has received more favorable
tax treatment than operating income.

Corporate Capital Gains /

Losses

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Currently, capital gains are taxed

at 20%, if indexed value is used for
corporations, or 10% on historical
cost.

Capital losses are deductible only

against capital gains.

Calculating the Incremental

Cash Flows

Initial cash outflow -- the initial net cash

investment.

Interim incremental net cash flows -those net cash flows occurring after the
initial cash investment but not including
the final periods cash flow.

Terminal-year incremental net cash flows

-- the final periods net cash flow.

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Initial Cash Outflow

a)
b)
c)
d)
e)
f)
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Cost of new assets

+
Capitalized expenditures
+ (-) Increased (decreased) NWC
Net proceeds from sale of
old asset(s) if replacement
+ (-) Taxes (savings) due to the sale
of old asset(s) if replacement
=
Initial cash outflow

Incremental Cash Flows

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a)

Net incr. (decr.) in operating revenue

less (plus) any net incr. (decr.) in
operating expenses, excluding depr.

b)

- (+) Net incr. (decr.) in tax depreciation

c)

d)

- (+) Net incr. (decr.) in taxes

e)

f)

+ (-) Net incr. (decr.) in tax depr. charges

g)

Net change in income before taxes

Net change in income after taxes
Incremental net cash flow for period

Terminal-Year Incremental
Cash Flows
a)

Calculate the incremental net cash

flow for the terminal period

b)

+ (-) Salvage value (disposal/reclamation

costs) of any sold or disposed assets

c)

- (+) Taxes (tax savings) due to asset sale

or disposal of new assets

d)

+ (-) Decreased (increased) level of net

working capital

e)

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Terminal year incremental net cash flow

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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Initial Cash flow

a)
b)
c)
d)
e)
f)

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110,000
10,000
15,000
+
0 (not a replacement)
- (+)
0 (not a replacement)
=
-135,000

Depreciation Calculation

Initial Investment- Salvage Value

Depreciation= ------------------------------------------------Economic Life
110000-10000
= ------------------------------ = 25000
4
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Incremental Cash Flows

a)

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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

The incremental cash flow

from the previous slide in
Year 4.
Salvage Value.
NWC - Project ends.
Terminal-year incremental
cash flow.

Summary of Project Net

Cash Flows
Asset Expansion
Year 0
-135,000

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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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Initial Cash Outflow

a)
b)
c)
d)
e)
f)

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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)

Calculation of the Change

in Depreciation
a)
b)

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

a) Represent the depreciation on the new

project.
b) Represent the remaining depreciation on the
old project.
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c) Net change in tax depreciation charges.

Incremental Cash Flows

a)

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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

The incremental cash flow

from the previous slide in
Year 4.

10,000

Salvage Value.

b)

c)

d)

15,000 Return of added NWC.

e)

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38,500

Terminal-year incremental
cash flow.

Summary of Project Net

Cash Flows
Asset Expansion
Year 0
-135,000

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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Saraf Finial Fabricating Woks is considering automating its existing

finial casting and assembly department. The plant manager has
accumulated the following information for you:
The automation proposal would result in reduced labour costs of Rs.
1500000 per year.
The cost of defects is expected to remain at Rs. 50000 even if the
automation proposal is accepted.
New equipment costing Rs. 5000000 would need to be purchased. For
tax purposes, the equipment will be depreciated on a straight-line basis
over its useful four-year life. The estimated final salvage value of the new
equipment is Rs. 500000.
Annual maintenance costs will increase from Rs. 20000 to Rs. 80000 if
the new equipment is purchased.
The company is subject to marginal tax rate of 30 per cent.
What are the relevant incremental cash inflows over the proposals useful
life and what is the incremental cash outflow at time 0?

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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