Chapter 11: Capital Budgeting Cash Flows and Risk Refinements

Overview
This chapter expands upon the capital budgeting techniques presented in the previous chapter
(Chapter 10). Shareholder wealth maximization relies upon selection of projects that have
positive net present values. The most important and difficult aspects of the capital budgeting
process is developing good estimates of the relevant cash flows. Chapter 11 focuses on the basics
of determining relevant after-tax cash flows of a project, from the initial cash outlay to annual
cash stream of costs and benefits and terminal cash flow. It expands capital budgeting to consider
risk with such methods as scenario analysis and simulation. Additionally, two basic riskadjustment techniques are examined: certainty equivalents and risk-adjusted discount rates.

A Few Key Points:

Capital budgeting is the process used to evaluate and select long-term investments consistent
with the goal of owner wealth maximization. Capital expenditures are outlays made by the firm
that are expected to produce benefits over the long term (a period greater than one year). Not all
capital expenditures are made for fixed assets. An expenditure made for an advertising campaign
may have long-term benefits. A conventional cash flow pattern consists of an initial outflow
followed by a series of inflows. A nonconventional cash flow pattern is any pattern in which an
initial outlay is not followed by a series of inflows.
The primary motives for making capital expenditures include:
Expansionincreasing the productive capacity of the firm, usually through the acquisition
of fixed assets.
Replacementreplacing existing assets with new or more advanced assets that provide the
same function.
Renewalrebuilding or overhauling existing assets to improve efficiency.
Other motives include expenditures for nontangible projects that improve a firms profitability,
such as advertising, research and development, and product development. A firm may also be
required by law to undertake pollution control and similar projects.
Expansion and replacement involve the purchase of new assets as compared with renewal, where
old assets are upgraded.
Capital budgeting projects should be evaluated using incremental after-tax cash flows, since
after-tax cash flows are what is available to the firm. When evaluating a project, concern is
placed only on added cash flows expected to result from its implementation. Expansion decisions
can be treated as replacement decisions in which all cash flows from the old assets are zero. Both
expansion and replacement decisions involve purchasing new assets. Replacement decisions are
more complex because incremental cash flows resulting from the replacement must be
determined.
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The three components of cash flow for any project are (1) initial investment, (2) operating cash
flows, and (3) terminal cash flows.
Sunk costs are costs that have already been incurred and thus the money has already been spent.
Opportunity costs are cash flows that could be realized from the next best alternative use of an
owned asset. Sunk costs are not relevant to the investment decision because they are not
incremental. These costs will not change no matter what the final accept/reject decision.
Opportunity costs are a relevant cost. These cash flows could be realized if the decision is made
not to change the current asset structure but to utilize the owned asset for this alternative
purpose.
To minimize long-term currency risk, companies can finance a foreign investment in local
capital markets so that the projects revenues and costs are in the local currency rather than
dollars. Techniques such as currency futures, forwards, and options market instruments protect
against short-term currency risk. Financial and operating strategies that reduce political risk
include structuring the investment as a joint venture with a competent and well-connected local
partner; and using debt rather than equity financing, since debt service payments are legally
enforceable claims while equity returns such as dividends are not.

Steps in Capital Budgeting Process:

a. The cost of the new asset is the purchase price. (Outflow)
b. Installation costs are any added costs necessary to get an asset into operation. (Outflow)
c. Proceeds from sale of old asset are cash inflows resulting from the sale of an existing asset,
reduced by any removal costs. (Inflow)
d. Tax on sale of old asset is incurred when the replaced asset is sold due to recaptured
depreciation, capital gain, or capital loss. (May be an inflow or an outflow)
e. The change in net working capital is the difference between the change in current assets and
the change in current liabilities. (May be an inflow or an outflow)
f. The book value of an asset is its strict accounting value.
Book value = installed cost of asset accumulated depreciation
Gains and losses in the sale of an asset may have tax consequences, and hence are both key
forms of taxable income. More specifically, taxable income may arise from (1) capital gain:
portion of sale price above initial purchase price, taxed at the ordinary rate; (2) recaptured
depreciation: portion of sale price in excess of book value that represents a recovery of
previously taken depreciation, taxed at the ordinary rate; and (3) loss on the sale of an asset:
amount by which sale price is less than book value, taxed at the ordinary rate and deducted from
ordinary income if the asset is depreciable and used in business. If the asset is not depreciable or
is not used in business, it is also taxed at the ordinary rate but is deductible only against capital
gains.

The asset may be sold (1) for more than its book value, (2) for the amount of its book value, or
(3) at a price below book value. In the first case, taxes arise from the amount by which the sale
price exceeded the book value. In the second case, no taxes would be required. In the third case,
a tax credit would occur.
The depreciable value of an asset is the installed cost of a new asset and is based on the
depreciable cost of the new project, including installation cost.
Depreciation is used to decrease the firms total tax liability and then is added back to net profits
after taxes to determine cash flow. Table 8.7 and Equation 3.4 (refer to the text) are equivalent
ways of expressing operating cash flows. The earnings before interest and taxes in Table 8.7 is
the same as the EBIT terminology in Equation 3.4. Both models then take out taxes and add back
in depreciation.
To calculate incremental operating cash inflow for both the existing situation and the proposed
project, the depreciation on assets is added back to the after-tax profits to get the cash flows
associated with each alternative. The difference between the cash flows of the proposed and
present situation, the incremental after-tax cash flows, are the relevant operating cash flows used
in evaluating the proposed project.
The terminal cash flow is the cash flow resulting from termination and liquidation of a project at
the end of its economic life. The form of calculating terminal cash flows is shown below:
Terminal Cash Flow Calculation:

After-tax proceeds from sale of new asset + NWC = Terminal Cash Flow
The relevant cash flows necessary for a conventional capital budgeting project are the
incremental after-tax cash flows attributable to the proposed project: the initial investment, the
operating cash inflows, and the terminal cash flow. The initial investment is the initial outlay
required, taking into account the installed cost of the new asset, proceeds from the sale of the old
asset, tax on the sale of the old asset, and any change in net working capital. The operating cash
inflows are the additional cash flows received as a result of implementing a proposal. Terminal
cash flow represents the after-tax cash flows expected to result from the liquidation of the project
at the end of its life. These three components represent the positive or negative cash flow impact
if the firm implements the project and are depicted in the following diagram for a project lasting
five years.
Financing costs are irrelevant cash flows even though they occur in the future. Why we dont
include financing costs in the CFs estimations?
The reason we dont include financing costs because they are used in the estimation of the PV of
future CFs. Remember, the discount rate used to estimate PV (and in turn the NPV) is nothing
but the cost of capital.
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Risk-adjusted discount rates (RADRs) reflect the return that must be earned on a given project in
order to adequately compensate the firms owners. The relationship between RADRs and the
capital asset pricing model (CAPM) is a purely theoretical concept. The expression used to value
the expected rate of return of a security Ri (Ri = RF + [ (RM RF)]) is rewritten substituting
an asset for a security. Because real corporate assets are not traded in efficient markets and
estimation of a market return, RM, for a portfolio of such assets would be difficult, the CAPM is
not used for real assets.
A firm whose stock is actively traded in security markets generally does not increase in value
through diversification. Investors themselves can more efficiently diversify their portfolio by
holding a variety of stocks. Since a firm is not rewarded for diversification, the risk of a capital
budgeting project should be considered independently rather than in terms of their impact on the
total portfolio of assets. In practice, management usually follows this approach and evaluates
projects based on their total risk.
RADRs are most often used in practice for two reasons: (1) financial decision makers prefer
using rate of return-based criteria, and (2) they are easy to estimate and apply. In practice, risk is
subjectively categorized into classes, each having a RADR assigned to it. Each project is then
subjectively placed in the appropriate risk class.
A comparison of NPVs of unequal-lived, mutually exclusive projects is inappropriate because it
may lead to an incorrect choice of projects. The annualized net present value (ANPV) converts
the NPV of unequal-lived projects into an annual amount that can be used to select the best
project.