Review: Financial Management Decisions

Liabilities and Equity Assets

Current Liabilities Current Assets

- Short-term Loans - Inventory
- Notes Payable Working- Short-term investment
Long-term Liabilities capital
- Marketable Securities
- long-term Loans (Bonds and stocks)
- Bonds management
Fixed Assets
Equity Equipments
- Preferred stocks
- Common Stocks
- Retained Earnings

Investment Financing
Decision Decision
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 Reviw: The Corporation and the Financial
Markets (Direct)
• The Firm and the Financial Markets
Firm Firm issues securities (A) Financial
markets
Invests
Retained
in assets (financial/ cash flows (F)
physical)
(B) Short-term deb
Cash flow Dividends and Long-term debt
Current assets from firm (C) debt payments (E)
Equity shares
Fixed assets

Taxes (D)

Bsc Principles of Finance Prof Abdelgadir 2

Government
 Capital Budgeting Cash Flows

Lecture 1
March 2023

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 Learning Outcomes
1. Understand the motives for key capital budgeting
expenditures and the steps in the capital
budgeting process.
2. Define basic capital
budgeting terminology.
3. Discuss relevant cash flows, expansion versus
replacement decisions, sunk costs and
opportunity costs.
4. Calculate the three types of cash flows for a
project: Initial, operating and terminal

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 The Capital Budgeting Decision
• Capital Budgeting is the process of identifying,
evaluating, and implementing a firm’s investment
opportunities.
• It seeks to identify investments that will enhance a
firm’s competitive advantage and increase
shareholder wealth.
• The typical capital budgeting decision involves a large
up-front investment followed by a series of smaller
cash inflows.
• Poor capital budgeting decisions can ultimately result
in company bankruptcy.
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 Motives for Capital Expenditures

Motive Description

Expansion Capital expenditure to expand operations via

acquisition of fixed assets

Replacement When the growth reaches maturity , the firm

/ renewal need capital expenditure to increase efficiency by
replacing or renewing obsolete/ worn-out assets

Other Capital expenditures that do not result in the

acquisition of tangible fixed assets. Instead capital
expenditures for long term commitment in
expectation of future return. Examples: Research
and Development Project, new products

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 Steps in the Process

1. Proposal Generation

2. Review and Analysis

Our Focus
3. Decision Making

4. Implementation

5. Follow-up

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 Terminologies: Independent Mutually Exclusive and
Joint Projects

• Independent Projects, on the other hand, do not

compete with the firm’s resources. A company
can select one, or the other, or both—so long as
they meet minimum profitability thresholds.

• Mutually Exclusive Projects are investments that

compete in some way for a company’s resources
—a firm can select one or another but not both.
• Joint projects: Linked to each other and can not
be separated
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 Terminologies: Unlimited Funds versus Capital
Rationing

• If the firm has unlimited funds for making

investments, then all independent projects that are
economically feasible can be accepted
• However, in most cases firms face restrictions on
capital budgeting spending since they only have a
given amount of funds to invest in potential
investment projects at any given time.
• Here we have capital rationing
• Soft Vs. Hard rationing
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 Terminologies: Accept-Reject versus Ranking
Approaches
• The accept-reject approach involves the
evaluation of capital expenditure proposals to
determine whether they meet the firm’s
minimum acceptance criteria.
• The ranking approach involves the ranking of
capital expenditures on the basis of some
predetermined measure, such as the rate of
return.

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 Terminologies: Conventional Cash Flows

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Terminologies: Nonconventional Cash Flows

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 The Relevant Cash Flows
• Incremental cash flows:
Are cash flows specifically associated with the
investment, and their effect on the firms other
investments (both positive and negative) must
also be considered.
For example if you decide to open a new branch
of your restaurant in a different area, the impact
of customers who move from the present one to
the new one must be considered.

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 Relevant Cash Flows: Sunk Costs Versus Opportunity Costs

• Note that cash outlays already made (sunk costs)

are irrelevant to the
decision process. They should not be included in a
project’s incremental cash flows
• However, opportunity costs, which are cash flows
that could be realized from the best alternative
use of the asset,
are relevant.
• They should be included as cash outflows when
you calculate a project’s incremental cash flows
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 Relevant Cash Flows:
Major Cash Flow Components

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 Expansion Versus Replacement Decisions

• Estimating incremental cash flows is relatively

straightforward in the case of expansion
projects, but not so in the case of
replacement projects.
• With replacement projects, incremental cash
flows must be computed by subtracting
existing project cash flows from those
expected from the new project.

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 Relevant Cash Flows: Expansion Versus
Replacement Cash Flows
How to calculate the three relevant cash flow
in case of replacement?
• Initial investment= Initial investment needed to acquire
new asset – after tax cash inflow of liquidating old asset

• Operating cash inflows = operating cash inflows from new

asset- operating cash inflows of old asset

• Terminal cash flow= After tax cash flows form termination

new asset- after tax cash flow of termination of old asset
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 Finding the Initial Investment
How to determine initial investment in case of replacement?
Installed cost of the new asset=
cost of new asset + installation costs

- after tax proceeds of selling old asset =

Proceeds of selling old asset +/- tax of sale of old asset
+/- change in net working capital

= Initial Investment

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 Finding the Initial Investment (cont.):
The Impact of tax
Form of taxable Definition Tax treatment Assumed
income tax rate

Gain on Sale price Gains taxed as ordinary 20%

sale of > Book income
asset value
Loss on sale Sale price If asset is depreciable and 20% of
of asset < Book used in business, loss is loss is a
value deducted from ordinary tax
income savings
- If asset is not depreciable 20% of
or is not used in business, loss is a
loss is deductible only tax
against capital gains savings
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 Example
• A machine was purchased 2 years ago with an installed costs
of $100000. The accumulated depreciation after 2 years =
$52000, which means that the book value = 100000- 52000 =
48000
Case 1: The machine was sold for $110000.
 Here the company realized a gain of (110000 -48000) = $
62000
 The difference between the cost and the book value (100000-
48000) = $52000 is called the recaptured depreciation
 The difference between the sale price and the cost (110000-
100000) = $10000 is called a capital gain
 Therefore, the company must pay taxes on capital gains and
the recaptured depreciation at its marginal tax rate
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 Case 2: Sale of the Asset for More Than Its Book Value but Less
than Its Purchase Price

• If the machine was sold for $70000.

• In this case the company realized a gain the

form of recaptured depreciation of (70000 –
48000) = $22000 and it has to be taxed

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 Case 3
• If Hudson sells the old asset for its book value
of $48,000, there is no gain or loss and
therefore no tax implications from the sale.

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 Case 4: Sale of the Asset for Less Than Its Book Value

• If the company sells the old asset for $30,000 which is less
than its book value of $48,000, it experiences a loss of
$18,000 ($48,000 - $30,000).
• If this is a depreciable asset used in the business, the loss may
be used to offset ordinary operating income.
• If it is not depreciable or not used in the business, the loss can
only be used to offset capital gains.
• If the tax rate is 20%, in either case the loss will save the firm
$3600 (0.20*18000) in taxes
• If current operating earnings or capital gains are not sufficient
to offset the loss, the firm may be able to apply these losses
to prior or future taxes.
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 Change in Net Working Capital
• For example if you buy a new photocopier it will
require increase in some form of current assets
and current liabilities
• The difference between current assets and
current liabilities is net working capital (NWC)
• Normally current assets increase more than
current liabilities which means increased
investment in net working capital
• NWC is treated as an investment initially and
recovered at the end of the project
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 Example: Initial Investment
• A large diversified manufacturer of aircraft components, is trying to
determine the initial investment required to replace an old machine
with a new, more sophisticated model. The machine’s purchase
price is $380,000 and an additional $20,000 will be necessary to
install it. It will be depreciated under MACRS using a 5-year
recovery period (20%,32%,19%,12%,12% and 5%). The present
machine was bought 3 years ago for $240000 and has been
depreciated under MACRS using a 5-year recovery period. The firm
has found a buyer willing to pay $280,000 for the present machine
and remove it at the buyer’s expense. The firm expects that a
$35,000 increase in current assets and an $18,000 increase in
current liabilities will accompany the replacement. Both ordinary
income and capital gains are taxed at 40%.
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 Example: Initial Investment

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 Example: Operating Cash Inflows

• The estimates of the revenues and expenses

(excluding depreciation and interest), with and
without the new machine described in the preceding
example, are given below. Note that both the
expected usable life of the proposed machine and
the remaining usable life of the existing machine are
5 years. The amount to be depreciated with the
proposed machine is calculated by summing the
purchase price of $380,000 and the installation costs
of $20,000.

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 Revenues and expenses
Proposed Machine Present Machine
Year Revenue Expenses Year Revenue Expenses
(excluding Dep. (excluding Dep.
and interest) and interest)

1 2520000 2300000 1 2200000 1990000

2 2520000 2300000 2 2300000 2110000
3 2520000 2300000 3 2400000 2230000
4 2520000 2300000 4 2400000 2250000
5 2520000 2300000 5 2250000 2120000
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 Depreciation: Proposed Machine
Year Cost MACRS % Depreciation
1 400000 20 80000
2 400000 32 128000
3 400000 19 76000
4 400000 12 48000
5 400000 12 48000
6 400000 5 20000
Total 100% 400000

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 Depreciation: Present Machine
Year Cost MACRS % Depreciation
1 240000 12 28800
2 240000 12 28800
3 24000 5 12000
4 Because the present machine is 0
at the end of the third year of its
5 cost recovery at the time of the 0
6 analysis, it has only the final 3 0
years of depreciation
Total 100% 69600
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 Operating Cash Flow
Revenue
- Expenses (excluding depreciation and Interest)
= EBDIT
- Depreciation
= EBIT
- Interest
= EBT
- Tax
Net Operating profit after tax = EBIT(1-Tax rate)
+ Depreciation
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Operating Cash Inflows CF SMS 2023 31
 OCF: Proposed Machine
Year 1 2 3 4 5 6
Revenue 2520000 2520000 2520000 2520000 2520000 0
Expenses 2300000 2300000 2300000 2300000 2300000 0
(excluding
depreciation and
Interest)
EBDIT 220000 220000 220000 220000 220000
Depreciation 80000 128000 76000 48000 48000 20000
EBIT 140000 92000 144000 172000 172000 -20000
Tax 40% 56000 36800 57600 68800 68800 - 8000
Net Operating 84000 55200 86400 103200 103200 -12000
profit after tax =
EBIT(1-Tax rate)
Depreciation 80000 128000 76000 48000 48000 20000
Operating Cash 164000 183200 162400 151200 151200 8000
Inflows

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 OCF: Present Machine
Year 1 2 3 4 5 6
Revenue 2200000 2300000 2400000 2400000 2250000 0
Expenses 1990000 2110000 2230000 2250000 2120000 0
(excluding
depreciation and
Interest)
EBDIT 210000 190000 170000 150000 130000 0
Depreciation 28800 28800 12000 0 0 0
EBIT 181200 161200 158000 150000 130000 0
Tax 40% 72480 64480 63200 60000 52000 0
Net Operating 108720 96720 94800 90000 78000 0
profit after tax =
EBIT(1-Tax rate)
Depreciation 28800 28800 12000 0 0 0
Operating Cash 137520 125520 106800 90000 78000 0
Inflows

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 Incremental Operating Cash Flows
year OCF Proposed Machine 1 OCF Present Machine 2 Incremental OCF 3= 1-2

1 164000 137520 26480

2 183200 125520 27680
3 162400 106800 55600
4 151200 90000 61200
5 151200 78000 73200
6 8000 0 8000

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 Terminal CF
• If the firm expects to be able to liquidate the
new machine at the end of its 5-year useable
life to net $50,000 after paying removal and
cleanup costs. The old machine can be
liquidated at the end of the 5 years to net
$10,000. The firm expects to recover its
$17,000 net working capital investment upon
termination of the project. Again, the tax rate
is 40%.

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 Terminal CF

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Should the Firm take the replacement Decision?
• If the required rate of return is 10%, should
the company replace the old machine?

• To answer the question, we need to calculate

the net present value (NPV)

• If NPV is positive the company can take the

make the replacement and if negative the
company should continue with old machine
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 NPV
Year CF PV F 10% PV
0 221160 1 (221160.00)
1 26480 0.909 24,070.32
2 27680 0.826 21,872.48
3 55600 0.751 41,755.6
4 61200 0.683 41,799.6
5 73200 + 49000 0.621 75,886.2
NPV = -15775.88

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 Problems

1- A firm is considering a purchase of a new truck to replace the

current one. The new one costs $75000 and requires $5000 in
installation costs. It will be depreciated under MACRS using a 5 year
recovery period ( 20%, 32%, 19%, 12%, 12% and 5%). The present
truck was purchased 4 years ago for an installed cost of $50000; it
was being depreciated under MACRS using a 5-year recovery period.
The present truck can be sold today for $55000. The proposed
replacement the firm has to invest in net working capital $15000.
The firm pays taxes at a rate of 40%.
1- Calculate the book value of the old truck
2- Determine the taxes, if any, attributable to the sale of the old
truck.
3- Find the Initial investment associated with the proposed truck
replacement.

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 Problems

2- A firm considers an investment in photocopying project that

requires a purchase of a new photocopier that costs $ 10000 in
addition to $2000 for installation and $800 as net working capital .
The economic life of the copier is 4 years depreciated to zero at the
end of the 4th. Year. It can be sold after that for $1000. The annual
cash revenue $8000 and the operating expenses are $4000. The tax
rate is 40%.
1- Calculate the initial investment
2- Determine the operating cash inflows
3- Find the terminal cash flow
4- If the opportunity cost of capital is 8%, should the company
purchase the copier? Use NPV

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 Problems
3- Fatima Computing Company is studding the feasibility of replacing its present
computers with more modern ones.
The present computers: have book value of $30000 and have a remaining
economic life of 6 years during which they will be depreciated via straight line
method. They can be sold now for $35000. In case the company decides to
continue with them, net profit will be $40000, 50000, 45000, 40000, 55000, and
35000 respectively.
The proposed computers: they cost $120000 in addition to $6000 for installation
and $ 5000 as net working capital. The will be depreciated to zero using the
straight line method. However, they will be sold for $10000 at the end of year 6.
Net profit will be: $50000, 65000, 75000, 80000, 100000, 130000 respectively.
The tax rate is 50%
Required:
1- initial investment in case of replacement
2- incremental operating cash inflows
3- terminal cash flow
4- if the discount rate is 12, should Fatima replace?
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