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BU7300 - Corporate Finance Capital Budgeting Week 1

The document provides an overview of capital budgeting concepts including relevant cash flows, asking the right question, key definitions, motives for capital expenditures, the capital budgeting process, depreciation, common cash flows, pro forma statements, and calculating project cash flows. It discusses focusing the analysis on incremental cash flows, defines capital budgeting terms, and outlines the steps in the capital budgeting process from proposal generation to follow up.

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Moony Tamimi
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58 views

BU7300 - Corporate Finance Capital Budgeting Week 1

The document provides an overview of capital budgeting concepts including relevant cash flows, asking the right question, key definitions, motives for capital expenditures, the capital budgeting process, depreciation, common cash flows, pro forma statements, and calculating project cash flows. It discusses focusing the analysis on incremental cash flows, defines capital budgeting terms, and outlines the steps in the capital budgeting process from proposal generation to follow up.

Uploaded by

Moony Tamimi
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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BU7300 - Corporate Finance Capital Budgeting

Week 1
Relevant Cash Flows

• The cash flows that should be included in a capital budgeting analysis


are those that will only occur (or not occur) if the project is accepted.

• These cash flows are called incremental cash flows.

• The stand-alone principle allows us to analyze each project in isolation


from the firm simply by focusing on incremental cash flows.
Asking the Right Question

• You should always ask yourself “Will this cash flow occur ONLY if we
accept the project?”
 If the answer is “yes,” it should be included in the analysis because it is incremental.

 If the answer is “no,” it should not be included in the analysis because it will occur
anyway.

 If the answer is “part of it,” then we should include the part that occurs because of
the project.
Capital budgeting – key definitions
• Capital budgeting
Process of evaluating long term investments
• Capital expenditure
Outlay of funds expected to produce benefits over a period more than
a year
• Operating expenditure
Outlay of funds expected to produce benefits within a year

4
Motives for capital expenditure decisions

• Expansion
• Replacement
• Renewal
• Other
• Requirements under environmental laws
• Health and safety laws, etc)

5
Steps in capital budgeting process
1. Proposal generation
2. Review and analysis
3. Decision-making
4. Implementation
5. Follow up

6
Depreciation

• The depreciation expense used for capital budgeting should be the


depreciation schedule required by the IRS for tax purposes.

• Depreciation itself is a non-cash expense; consequently, it is only


relevant because it affects taxes.

• Depreciation tax shield = D × T


 D = depreciation expense
 T = marginal tax rate
Computing Depreciation

• Straight-line depreciation
 D = (Initial cost – salvage) / number of years
 Very few assets are depreciated straight-line for tax purposes.
Common Types of Cash Flows

• Sunk costs – costs that have accrued in the past

• Opportunity costs – costs of lost options

• Side effects
 Positive side effects – benefits to other projects
 Negative side effects – costs to other projects

• Changes in net working capital

• Financing costs

• Taxes
Pro Forma Statements and Cash Flow

• Capital budgeting relies heavily on pro forma accounting statements,


particularly income statements.

• Computing cash flows – refresher


 Operating Cash Flow (OCF) =
EBIT + depreciation – taxes

 OCF = Net income + depreciation


(when there is no interest expense)

 Cash Flow From Assets (CFFA) =


OCF – net capital spending (NCS) – changes in NWC
Table1.1 Pro Forma Income Statement

Sales (50,000 units at $4.00/unit) $200,000


Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 17,430
Depreciation ($90,000 / 3) 30,000
EBIT $ 27,570
Taxes (21%) 5,790
Net Income $ 21,780
Table 1.2 Projected Capital Requirements

Year
0 1 2 3
NWC $20,000 $20,000 $20,000 $20,000

NFA 90,000 60,000 30,000 0

Total $110,000 $80,000 $50,000 $20,000


Table 1.5 Projected Total Cash Flows

Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change -$20,000 20,000
in NWC
NCS -$90,000

CFFA -$110,00 $51,780 $51,780 $71,780


Making The Decision

• Now that we have the cash flows, we can apply the techniques that
we learned.

• Enter the cash flows into the calculator and compute NPV and IRR.
 CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780; F02 = 1
 NPV; I = 20; CPT NPV = 10,648
 CPT IRR = 25.8%

• Should we accept or reject the project?


More on NWC

• Why do we have to consider changes in NWC separately?


 GAAP requires that sales be recorded on the income statement when made,
not when cash is received.

 GAAP also requires that we record cost of goods sold when the corresponding
sales are made, whether we have actually paid our suppliers yet.

 Finally, we have to buy inventory to support sales, although we haven’t


collected cash yet.
Calculation of project cash flows
• Calculate changes in investment in non-cash net working capital
If NWC rises, cash flows out
If NWC falls, cash flows in

• Changes in NWC take into account differences between accrual and cash
accounting

• Calculate changes in capital expenditure


• Ignore principal and interest payments - the project’s return must be sufficient to
cover cost of capital

16
Free cash flows to firm

• Cash flows available to suppliers of funds to firm


• In each period, free cash flows to the firm (FCF) should
be calculated as:

FCFt  NOPAT t  D t -NWCt -CE t


NOPAT t  net operating profit after  tax
 EBIT(1  t)
D t  depreciati on per period
ΔNWC t  NWCt 1  NWCt
 investment in NWC in period t
CE t  capital exp enditure in period t

17
Example

You are considering going into business to produce and sell a new product.
• The initial market research cost you $10,000 to carry out

• For tax purposes, you can use straight-line depreciation of the full installed cost of
$180,000 over an expected useful life of five years. You expect to sell it for
$50,000 at the end of five years.

• Market research indicates that you can expect sales revenue to total $375,000 in
the first year of business. You assume that there will be no growth in revenue in
the remaining four years you intend using the machine.

18
Example
• Expected annual fixed explicit operating costs are $25,000 and variable operating
costs are 70% of total sales.

• Immediate net working capital requirements will be $10,000. You expect that this
initial investment in working capital will be released at the end of the project. You
believe that no additional working capital will be required over the next five
years.

• The tax rate for income and recaptured depreciation is 33%. There is no capital
gains tax. You estimate that the after-tax cost of capital is 15% a year for the
project.

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Year 0 1 2 3 4 5
Investment in net working capital
Book value at the beginning of year
Book value at the end of the year
Recaptured depreciation
Tax on recaptured deprecation
Operating Revenue
Variables operating cost
Fixed operating cost
Depreciation
Operating profit
Tax on Operating profit
Tax on recaptured depreciation
NOPAT
Depreciation
Investment in networking capital
Capital expenditures
Cash flows
Tax on recaptured deprecation
Operating Revenue 375,000 375,000 375,000 375,000
Variables operating cost (262,500) (262,500) (262,500)
Fixed operating cost (25,000) (25,000) (25,000)
Depreciation (36,000) (36,000) (36,000)
Operating profit 51,500 51,500 51,500
Tax on Operating profit (16,995) (16,995) (16,995)
Tax on recaptured depreciation
NOPAT 34,505 34,505 34,505
Depreciation 36,000 36,000 36,000
Investment in networking capital 10,000 0 0 0
Capital expenditures 180,000
Cash flows (190,000) 70,505 70,505 70,505

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