Chapter 8 capital, budgetting & cash flow principles

Relevant Cash Flows The incremental after tax cash outflow and resulting subsequent inflows associated with a proposed capital project..  Incremental Cash Flows: the additional cash

to accompany

Chapter 8

Capital Budgeting & Cash Flow Principles

Learning Goals:

 Understand what motivates capital expenditure.

 Understand the steps in the capital budgeting

process.

 Define basic capital budgeting terminology.

 Discuss relevant features of capital projects.

 Calculate the initial and terminal amounts associated with a proposed capital expenditure.

 Find the relevant operating cash inflows using the income statement format and the formula method.

 Determine the terminal cash flow associated with a

The Capital Budgeting

Decision Making Process

 Capital Budgeting: the process of evaluating and

selecting long term investments consistent with the firm’s goal of maximising owner wealth.

 Capital Expenditure: an outlay of funds by the firm

that is expected to produce benefits over a period

of time greater than one year.

 Operating Expenditure: an outlay of funds resulting

in benefits being received within one year.

Cash Flow Patterns

Relevant Cash Flows

 The incremental after tax cash outflow and

resulting subsequent inflows associated with a proposed capital project.

 Incremental Cash Flows: the additional cash

inflows and outflows expected from a proposed capital project.

Cash Flow Components

• The cash flows of any project having a conventional cash flow pattern will have three components:

1 Initial Investment: the relevant cash outflow at

time zero.

2 Annual Operating Net Cash Inflow: the

incremental annual after-tax net cash inflows resulting from implementation during a project’s life.

3 Terminal Cash Flow: the after tax non-operating

cash flow occurring in the final year of the project

Cash Flow Components

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Issues When Using Relevant

Cash Flows In Capital Budgeting

 Interest and other financing costs are not included in projected annual cash flow calculations.

 Opportunity and sunk costs are often mishandled or ignored.

 International capital budgeting must consider

political and currency risks.

Issues When Using Relevant

Cash Flows In Capital Budgeting

 Identifying cash flows for replacement decisions is

more complex than for expansion decisions.

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Finding The Initial Investment

Installed cost of new asset

- After tax proceeds from sale of old asset

+/- Change in net working capital

= Initial investment

 Installed Cost: includes the cost of the new asset

and any installation costs necessary to place the

asset into operation.

 After Tax Proceeds From The Sale Of An Asset: the

difference between the old asset’s sale proceeds

and any applicable taxes/tax refunds relating to its sale.

Tax payable on the sale of the old asset depends on the relationship between its sale price, book value, and relevant tax legislation.

Finding The Initial Investment

 The net value of an asset shown on the firm’s

Balance Sheet

Book Value =installed – accumulated [ Equation 8.1]

cost depreciation

Book Value

 Three potential tax situations arise when selling

an asset:

Potential Tax Situations From The Sale Of Assets

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Potential Tax Situations From The Sale Of Assets

Change In Net Working Capital

 The difference between the change in current assets and the change in liabilities

 If the positive it is treated as an initial outflow

 If negative it is treated as an initial inflow associated with the

project.

 Is not taxable.

 At the end of the project’s life, the overall net working capital

is recovered as a cash inflow.

Change In Net Working Capital

Finding The Annual Operating Net Cash Inflows

 Interpretation Issues:

 The term “after tax” means net of any tax

deductions or benefits the investment may

generate.

 The term “annual net cash inflows” means

measuring all expected benefits on an actual dollar basis, not just an accounting basis.

 The term “incremental” means only changes

in net operating cash flows as a result of the

project are included.

Calculating Annual Operating Net Cash Inflows – The

Income Statement Method

 Involves adding any non-cash charges deducted

as expenses in the firm’s Income Statement back

to net profits after taxes.

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 Is calculated by:

Where:

ONCI t = Operating net cash inflow

PBDIT t = Profit before depreciation, interest and

taxes

D t = Depreciation expense in year t

T = the firm’s marginal income tax rate

Calculating Annual Operating Net Cash Inflows – The

Formula Method

) (

)]

1 (

PBDIT t = Change in profits before

depreciation, interest and taxes.

D t = Depreciation expense in year t

) (

)]

1 (

Terminal Cash Flow

 The cash flow resulting from termination and

liquidation of a project at the end of its economic life.

It represents the after tax cash flows exclusive of

operating net cash inflows, that occurs in the final

year of project.

 “Scrap/Salvage Value” is the proceeds from the sale

of the old asset, net of any removal or clean up costs, expected on termination of the project

 Tax will apply whenever an asset is sold for a value different from its book value.

Finding The Terminal Cash

Flow

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Calculating Working Capital

Changes On An Annual Basis

 Where revenue and costs are expected to vary

significantly over the life of the project it will be more accurate to calculate closing working capital as a

proportion of annual revenue or some substitute

measure of activity.

Calculating Working Capital Changes On An Annual Basis

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