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1、Reading 25 Capital Budgeting Copyright FinQ. All rights reserved. 2 0 1 3 Capital Budgeting is the process that companies use for decision making on capital projects i.e. long-term projects or investments. There are three ways to organize the cash flows information: i. Table format with Cash flows c
2、ollected by year. See table 14 on page 29, Reading 25, Curriculum, Volume 3. ii. Table format with cash flows collected by type. See table 15 on page 30, Reading 25, Curriculum, Volume 3. iii. Using equations as explained below. Depreciation Depreciation is non-cash operating expense and it is an im
3、portant part of estimating operating cash flows because it is a source of tax savings. Generally, higher depreciation results in lower income and higher cash flows. Hence, use of accelerated depreciation method results in higher after-tax cash flows in the early life of the project and lower after-t
4、ax cash flows in later life as compared to straight line depreciation method. Thus, accelerated depreciation method improves the NPV of the project as compared to straight-line depreciation method. Depreciation which is used for tax reporting purposes is used for capital budgeting purposes since cap
5、ital budgeting analysis is based on after- tax cash flows not on accounting income. Modified Accelerated Cost Recovery System (MACRS) method is generally used for tax purposes. Under MACRS, assets are classified into 3, 5, 7, or 10 year classes and each years depreciation is determined by the applic
6、able percentage given. Source: Table 16, Volume 3, Reading 25, P. 30-31 Assumption used in MACRS: It is assumed that depreciation period is started at middle of the year. For example, for a 3-year class asset, depreciation percentages are given for 4 years. Depreciable Basis = Purchase price + any S
7、hipping or handling or installation costs NOTE: Depreciation basis is not adjusted for salvage value either in accelerated or straight line method. 5.3 Equation Format for Organizing Cash Flows 1. Expansion Project: It is an investment in a new asset to increase both the size and earnings of a busin
8、ess. It is an independent investment that does not affect the cash flows for the rest of the company. a) Initial Outlay: Outlay = FCInv + NWCInv where, FCInv = investment in new capital NWCInv = investment in net working capital = non-cash current assets non-debt current liabilities = NWC NOTE: when
9、 NWCInv is positive, it represents cash outflow and when NWCInv is negative it represents cash inflow. b) Annual after-tax operating cash flow: CF = (S C D) (1 T) + D or CF = (S C) (1 T) + TD where, S = sales C = cash operating expenses D = depreciation expense T = marginal tax rate c) Terminal year
10、 after-tax non-operating cash flow: TNOCF = Sal T + NWCInv T (Sal T B T) where, Sal T = cash proceeds (salvage value) from sale of fixed capital on Termination date B T = book value of fixed capital on termination date Example: FCInv = 200,000 NWCInv = 30,000 S = 220,000 C = 90,000 D = 35,000 T = 40
11、% or 0.40 Sal T = 50,000 B T = 25,000 n = 5 Outlay = 200,000 + 30,000 = $230,000 CF = (220,000 90,000 35,000) (1 0.40) + 35,000 = $92,000 or CF = (220,000 90,000) (1 0.40) + (0.40 35,000) = $ 92,000 TNOCF = 50,000 + 30,000 0.40 (50,000 25,000) = $70,000 NPV is calculated as follows: CF0 = -230,000 C
12、F1 = 92000 CF 2 = 92000 CF 3 = 92000 CF4 = 92000 CF 5 = 92000 + 70000 I = 10% Compute NPV = $162,217 2. Replacement Project: It is a project when a firm replaces existing asset with a newer or better asset. It must deal with the difference between the cash flows that occur with the new investment an
13、d the cash flows that would have occurred for the existing investment. CFs analysis is more complicated in this type of investment. 153Reading 25 3. Initial Outlay: Outlay = FCInv + NWCInv Sal 0 + T (Sal where, FCInv = investment in new capital NWCInv = investment in net working capital= non-cash cu
14、rrent assets non-current liabilities = NWC NOTE: when NWCInv is positive, it represents cash outflow and when NWCInv is negative it represents cash inflow.Sal 0 = cash proceeds (salvage value) from sale of old fixed capital B0 = book value of old fixed capital 4. Annual after-tax operating cash flow
15、 i.e. Incremental Operating CFs: CF = (S C D) (1 T) + D or CF = (S C) (1 T) + TD where, S = change in sales or incremental sales C = change in cash operating expenses or incremental cash operating expenses D = change in depreciation expense or incremental depreciation expense T = marginal tax rate 5. Terminal year after-tax non-operating cash flow:TNOCF = Sal T + NWCInv T (Sal T where, Sal T = cash proceeds (salvage value) from sale of fixed capital on Termination date B T = book value of fixed capital on termination dateExample: Old Equ
