Study Guide in Financial Management FM-AA-CIA-15 Rev.

0 03-June-2020

FM 101: Financial Management Module 7: Capital Budgeting and Estimating

Module No. 7
Capital Budgeting and Estimating Cash Flow

MODULE OVERVIEW

Capital Budgeting is used for decision making of the long term investment that whether
the projects are fruitful for the business and will provide the required returns in the future
years and it is important because capital expenditure requires huge amount of funds so
before doing such expenditure in capital asset management do capital budgeting to
assure themselves that the capital spending will bring profits in the business.

Capital Budgeting is the formal process of investments or expenditure that is huge in

amount. It involves the company’s major decision where to invest the current fund in the
development of the organization, such as for addition, disposition, modification, or
replacement of fixed assets. Capital budgeting becomes vital due to the vast amount of
investment that is involved and the risk associated with the same.

LEARNING OBJECTIVES

1. Define “capital budgeting” and identify the steps involved in the capital budgeting process.
2. Explain the procedure used to generate long-term project proposals within the firm.
3. Justify why cash, not income, flows are the most relevant to capital budgeting decisions.
4. Summarize in a “checklist” the major concerns to keep in mind as one prepares to determine
relevant capital budgeting cash flows.
5. Define the terms “sunk cost” and “opportunity cost” and explain why sunk costs must be
ignored, whereas opportunity costs must be included, in capital budgeting analysis.
6. Explain how tax considerations, as well as depreciation for tax purposes, affect capital
budgeting cash flows.
7. Determine initial, interim, and terminal period “after-tax, incremental, operating cash flows”
associated with a capital investment project.

LEARNING CONTENTS

CAPITAL BUDGETING PROCESS: AN OVERVIEW

What is Capital Budgeting?

Capital budgeting is the process of analyzing and ranking proposed projects to

determine which ones are deserving of an investment. The result is intended to be a
high return on invested funds. There are three general methods for deciding which
proposed projects should be ranked higher than other projects, which are (in declining
order of preference):

1. Throughput analysis. Determines the impact of an investment on the

throughput of an entire system.

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2. Discounted cash flow analysis. Uses a discount rate to determine the present
value of all cash flows related to a proposed project. Tends to create
improvements on a localized basis, rather than for the entire system, and is
subject to incorrect results if cash flow forecasts are incorrect.
3. Payback analysis. Calculates how fast you can earn back your investment; is
more of a measure of risk reduction than of return on investment.

These capital budgeting decision points are outlined in the following sections.

Throughput Analysis

Under throughput analysis, the key concept is that an entire company acts as a single
system, which generates a profit. Under this concept, capital budgeting revolves
around the following logic:

1. Nearly all of the costs of the production system do not vary with individual
sales; that is, nearly every cost is an operating expense; therefore,
2. You need to maximize the throughput of the entire system in order to pay for
the operating expense; and
3. The only way to increase throughput is to maximize the throughput passing
through the bottleneck operation.

Consequently, you should give primary consideration to those capital budgeting

proposals that favorably impact the throughput passing through the bottleneck
operation.

This does not mean that all other capital budgeting proposals will be rejected, since
there are a multitude of possible investments that can reduce costs elsewhere in a
company, and which are therefore worthy of consideration. However, throughput is
more important than cost reduction, since throughput has no theoretical upper limit,
whereas costs can only be reduced to zero. Given the greater ultimate impact on
profits of throughput over cost reduction, any non-bottleneck proposal is simply not as
important.

Discounted Cash Flow Analysis

Any capital investment involves an initial cash outflow to pay for it, followed by a mix
of cash inflows in the form of revenue, or a decline in existing cash flows that are
caused by expenses incurred. We can lay out this information in a spreadsheet to
show all expected cash flows over the useful life of an investment, and then apply a
discount rate that reduces the cash flows to what they would be worth at the present
date. This calculation is known as net present value. Net present value is the
traditional approach to evaluating capital proposals, since it is based on a single
factor – cash flows – that can be used to judge any proposal arriving from anywhere
in a company.

For example, ABC Company is planning to acquire an asset that it expects will yield
positive cash flows for the next five years. Its cost of capital is 10%, which it uses as
the discount rate to construct the net present value of the project. The following table
shows the calculation:

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Year Cash Flow 10% Discount Factor Present Value

0 -$500,000 1.0000 -$500,000
1 +130,000 0.9091 +118,183
2 +130,000 0.8265 +107,445
3 +130,000 0.7513 +97,669
4 +130,000 0.6830 +88,790
5 +130,000 0.6209 +80,717
Net Present Value -$7,196

The net present value of the proposed project is negative at the 10% discount rate, so
ABC should not invest in the project.

In the “10% Discount Factor” column, the factor becomes smaller for periods further in
the future, because the discounted value of cash flows are reduced as they progress
further from the present day. The discount factor can be derived from the following
formula:

Present value of a Future cash flow

future cash flow
= ----------------------------------------------------------------------------
(1 + Discount rate)squared by the number of periods of
discounting

Payback Analysis

The simplest and least accurate evaluation technique is the payback method. This
approach is still heavily used, because it provides a very fast calculation of how soon
a company will earn back its investment. This means that it provides a rough measure
of how long a business will have its investment at risk, before earning back the
original amount expended. Thus, it is a rough measure of risk. There are two ways to
calculate the payback period, which are:

1. Simplified. Divide the total amount of an investment by the average resulting

cash flow. This approach can yield an incorrect assessment, because a
proposal with cash flows skewed far into the future can yield a payback period
that differs substantially from when actual payback occurs.
2. Manual calculation. Manually deduct the forecasted positive cash flows from
the initial investment amount, from Year 1 forward, until the investment is paid
back. This method is slower to calculate, but ensures a higher degree of
accuracy.

For example, ABC Company has received a proposal from a manager, asking to

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spend $1,500,000 on equipment that will result in cash inflows in accordance with the
following table:

Year Cash Flow

1 +$150,000
2 +150,000
3 +200,000
4 +600,000
5 +900,000

The total cash flows over the five-year period are projected to be $2,000,000, which is
an average of $400,000 per year. When divided into the $1,500,000 original
investment, this results in a payback period of 3.75 years. However, the briefest
perusal of the projected cash flows reveals that the flows are heavily weighted toward
the far end of the time period, so the results of this calculation cannot be correct.
Instead, the cost accountant runs the calculation year by year, deducting the cash
flows in each successive year from the remaining investment. The results of this
calculation are:

Year Cash Flow Net Invested Cash

0 -$1,500,000
1 +$150,000 -1,350,000
2 +150,000 -1,200,000
3 +200,000 -1,000,000
4 +600,000 -400,000
5 +900,000 0

The table indicates that the real payback period is located somewhere between Year
4 and Year 5. There is $400,000 of investment yet to be paid back at the end of Year
4, and there is $900,000 of cash flow projected for Year 5. The cost accountant
assumes the same monthly amount of cash flow in Year 5, which means that he can
estimate final payback as being just short of 4.5 years.

The payback method is not overly accurate, does not provide any estimate of how
profitable a project may be, and does not take account of the time value of money.
Nonetheless, its extreme simplicity makes it a perennial favorite in many companies.

GENERATING INVESTMENT PROJECT PROPOSALS

Ideas for new capital investments can come from many sources, both inside and outside
a firm. Proposals may originate at all levels of the organization —from factory workers up
to the board of directors. Most large and medium -size firms allocate the responsibility for
identifying and analyzing capital expenditures to specific staff groups.

These groups can include cost accounting, industrial engineering, marketing research,
research and development, and corporate planning. In most firms, systematic procedures

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are established to assist in the search and analysis steps. For example, many firms
provide detailed forms that the originator of a capital expenditure proposal must complete.

These forms normally request information on the project’s initial cost, the revenues it is
expected to generate, and how it will affect the firm’s overall operating expenses. These
data are then channeled to a reviewer or group of reviewers at a higher level in the firm
for analysis and possible acceptance or rejection.

Where a proposal goes for review often depends on how the particular project
is classified.

Classifying Investment Projects

As noted earlier, there are several types of capital expenditures. These can be grouped
into projects generated by growth opportunities, projects generated by cost reduction
opportunities, and projects generated to meet legal requirements and health and safety
standards.

Projects Generated by Growth Opportunities

Assume that a firm produces a particular product that is expected to experience increased
demand during the upcoming years. If the firm’s existing facilities are inadequate to
handle the demand, proposals should be developed for expanding the firm’s capacity
such as Ford’s decision to expand Volvo’s manufacturing facilities, discussed in the first
section of the chapter. These proposals may come from the corporate planning staff
group, from a divisional staff group, or from some other source.

Because most existing products eventually become obsolete, a firm’s growth is also
dependent on the development and marketing of new products. This involves the
generation of research and development investment proposals, marketing research
investments, test marketing investments, and perhaps even investments in new plants,
property, and equipment. For example, in order for the mineral extraction industries to
keep growing, they must continually make investments in exploration and development. In
2002, ExxonMobil’s capital and exploration expenditures were $14.0 billion.

Similarly, firms in high-technology industries —such as electronics and pharmaceuticals—

must undertake continuing programs of research and development to compete
successfully. For example, Merck spent over $2.4 billion on research and development in
2002.

Projects Generated by Cost Reduction Opportunities

Just as products become obsolete over time, so do plants, property, equipment, and
production processes. Normal use makes older plants more expensive to operate
because of the higher cost of maintenance and downtime (idle time). In addition, new
technological developments may render existing equipment economically obsolete. These
factors create opportunities for cost reduction investments, which include replacing old,
obsolete capital equipment with newer, more efficient equipment.

Projects Generated to Meet Legal Requirements and Health and Safety Standards

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These projects include investment proposals for such things as pollution control,
ventilation, and fire protection equipment. In terms of analysis, this group of projects is
best considered as contingent upon other projects.

To illustrate, suppose USX wishes to build a new steel plant in Cleveland, Ohio. The
decision will be contingent upon the investment in the amount of pollution abatement
equipment required by state and local laws. Thus, the decision to invest in the new plant
must be based upon the total cost of the plant, including the pollution abatement
equipment, and not just the operating equipment alone. In the case of existing facilities,
this type of decision making is sometimes more complex.

For example, suppose a firm is told it must install new pollution abatement equipment in a
plant that has been in operation for some time. The firm first needs to determine the
lowest cost alternative that will meet these legal requirements. “Lowest cost” is normally
measured by the smallest present value of net cash outflows from the project. Then
management must decide whether the remaining stream of cash flows from the plant is
sufficient to justify the expenditure. If it appears as though it will not be, the firm may
consider building a new facility, or it may decide simply to close down the original plant.

Project Size and the Decision-Making Process

The classification of a proposed project influences the capital investment decision-making

process. However, there are other factors to consider —in particular, the size of the
expenditure required to carry out the project. Most firms decentralize the decision-making
function. For example, whereas the approval of the president and the board of directors
may be needed for especially large outlays, such as Ford’s $5 to $6 billion investment in
Volvo discussed earlier in the chapter, a divisional vice president may be the final
decision maker in the case of medium -size outlays.

A plant manager may have responsibility for deciding on smaller outlays, and a
department head in a particular plant may be authorized to approve small outlays. For
example, at Hershey Foods, a corporate -level review is required for all projects of more
than $500,000. Projects below this amount are evaluated at the operating division level
only. Hershey is moving toward a system that will require a corporate-level review for all
projects of $50,000 or more. This chain of command varies with individual companies. In
large firms, however, it is impossible for any one person to make every decision regarding
proposed capital expenditures, and a decentralized system is usually employed.

ESTIMATING PROJECT AFTER TAX INCREMENTAL OPERATING CASH FLOWS

Cash-Flow Checklist

Because cash flow is the lifeblood of any business, it should be under constant review
and optimization. Never is this truer than as the year comes to a close. Staying on top of
cash projections, cash movement, and your sources of cash is essential to avoid cash
shortfalls. Here are seven year-end steps you should take to review your cash flow
situation and plan for a cash flow positive.

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1. Review Your Cash Flow Statements

Your cash flow statement is a documented history of when cash enters (as receipts of
capital) and exits (bill payments, debt obligations, payroll, etc.) your business. It should
ideally be maintained monthly and can be used to assess your current cash position. At
year-end, however, spend some time reviewing statements for the prior 12 months for a
useful insight into cash flow trends. These can inform both your cash flow forecast for the
next 3–6 months and any steps you should take to mitigate recurring pitfalls (such as
perpetually late-paying clients).

2. Create a Cash Flow Forecast Schedule

Map out a plan to create and revisit your cash flow forecasts. At a minimum, forecasts
should be created for a 90-day period, but can extend to 6–12 months. Make a point of
revisiting your projections often and adjust your budget or business planning and
operations if cash flow is projected to be tight at any point during the year.

3. Correct Any Cash Flow Problems Before the Year’s Up

This will vary from business to business. For example, if you’re dealing with a stack of
unpaid invoices, chase them with the goal of closing them out before the year ends. If you
struggle because clients pay you on net 30, 60, or 90 day terms, find an alternative
source of cash, such as invoice financing, a line of credit, or a new sales strategy.

4. Review Your Pricing Strategy

Raising prices can help improve cash flow, and even a small raise across your customer
base helps. Just make sure to do prepare and pitch. Assess how much of a rise the
market will tolerate and be sure to communicate how you or your product/service delivers
value.

5. Create Sales Projections

Approach the new year with a methodical approach to setting sales targets—weekly,
monthly, or quarterly. As fellow Fundbox blogger, Rieva Lesonsky, explains:
“Projecting future sales over a specific time period enables you to plan better for all
elements of your business, from ordering inventory and budgeting for marketing
expenses to hiring new employees and obtaining necessary financing.”

6. Keep Working to Improve Collections

64% of small businesses regularly deal with late-paying clients, with nearly 50% of net 30
invoices being paid late. One of the most effective ways to deal with this is to review your
entire collections process: the way you invoice, how frequently, and who you put in
charge of collections. Find out where the bottlenecks are. If you’re a service-based
business, consider offering online payment options. According to Harvest, businesses
who offer online payment options get paid nearly 16 days sooner (twice as fast).

7. Plan Your Capital Needs

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Whether you plan to grow your business next year or need a back-up funding source,
start planning now to prevent a cash flow crunch. Business loans require preparation (a
business plan, at the minimum), strong credit (start building and monitoring yours now),
and solid financials (prepare and maintain your P&L statement, cash flow forecasts, and
balance sheet).

Tax Considerations

The discounted after-tax cash flow method is an approach to valuing an investment by

assessing the amount of money generated and taking into account the cost of capital
along with the applicable marginal tax rate.

Discounted after-tax cash flow is similar to simple discounted cash flow (DCF), but here
tax implications are also taken into consideration.

Understanding Discounted After-Tax Cash Flows

The purpose of discount analysis is to estimate the money an investor would receive
from an investment, adjusted for the time value of money. The time value of money
assumes that a dollar today is worth more than a dollar tomorrow because it can be
invested. As such, a DCF analysis is appropriate in any situation where a person is
paying money in the present with expectations of receiving more money in the future.

The discounted after-tax cash flow approach is mostly used in real estate valuation to
determine whether a particular property is likely to be a good investment. Investors must
consider depreciation, the tax bracket of the entity that will own the property, and any
interest payments when using this valuation method. It is a calculation of net cash flow
from a property after taxes and financing costs each year have been factored in. The
cash flow is discounted at the required rate of return of the investor to find the present
value of the after-tax cash flows. If the present value of the after-tax cash flow is higher
than the cost of investment, then the investment may be worth taking.

Since the discounted after-tax cash flow is calculated after-tax, even though it is not an
actual cash flow, depreciation must be used to determine the tax charge. Depreciation is
a non-cash expense that reduces taxes and increases cash flow. It is usually subtracted
from net operating income to derive the after-tax net income and then added back in to
reflect the positive impact it has on the after-tax cash flow.

Discounted After-Tax Cash Flows and Profitability

The discounted after-tax cash flow can be used to calculate the profitability index, a ratio
that evaluates the relationship between the costs and benefits of a proposed project or
investment. The profitability index, or benefit-cost ratio, is calculated by dividing the
present value of the discounted after-tax cash flow by the cost of the investment.

The rule of thumb asserts that a project with a profitability index ratio equal to or greater
than one is a potential profitable investment opportunity. In other words, if the present
value of the after-tax cash flow is equal to or higher than the cost of the project, the
project may be worth undertaking.

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Other Considerations

Because there are several different methods for valuing real estate investment, and each
method has its shortcomings, investors should not rely solely on discounted after-tax
cash flow to make a decision. To examine the property's value from multiple
perspectives, you can also use other methods of real estate valuation such as the cost
approach, sale comparison approach (SCA), and income approach.

The discounted after-tax cash flow is also used to calculate the

simple payback and discounted payback period of an investment, allowing an investor to
determine the length of time it would take for a project to recover the initial amount
invested in it.

INCREMENTAL CASH FLOWS

Essentially, incremental cash flow refers to cash flow that a company acquires when it
takes on a new project. If you have a positive incremental cash flow, it means that your
company’s cash flow will increase after you accept it. That’s a good indicator that it’s
worth investing in a project. On the other hand, a negative incremental cash flow indicates
that your cash flow will decrease, which means that it may not be the best option.

How to Calculate Incremental Cash Flow

Learning how to calculate incremental cash flow is relatively straightforward. You just
need to know a couple of basic pieces of information about your business’s finances.
Then, you can use the following incremental cash flow formula:

Incremental Cash Flow = Revenues – Expenses – Initial Cost

Incremental Cash Flow Example

It’s always useful to look at an incremental cash flow example to see how this process
works in real life. Imagine Company A wants to develop a new product and is looking at
two different options: Product 1 and Product 2. Incremental cash flow analysis is a great
way for Company A to determine which option to go into production with.

Product 1 is projected to have revenues of £200,000, expenses of £90,000, and an initial

cash outlay of £15,000. By contrast, Product 2 is expected to bring in revenues of
£500,000, but will require expenses of £350,000 and initial costs of £65,000

Product 1 ICF = 200,000 – 90,000 – 15,000 = £95,000

Product 2 ICF = 500,000 – 350,000 – 65,000 = £85,000

As you can see, although the projected revenues of Product 1 are substantially lower than
those of Product 2, the resulting incremental cash flow is £10,000 more because Product
2 has higher expenses, as well as a more significant cash outlay. Using incremental cash
flow analysis, Company A can determine that Product 1 is the better option.

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Advantages of Incremental Cash Flow Analysis

Incremental cash flow analysis can be an excellent tool for businesses that need to
decide whether to invest in certain assets. If you have a cash surplus and can’t work out
whether it’s a better idea to expand an existing product line or invest in a new one,
whichever option has the highest incremental cash flow may be your best bet.

Difficulties in Determining Incremental Cash Flow

Incremental cash flows are helpful, especially in determining if a company should take on
a new project or not. However, accountants also encounter certain difficulties when
estimating incremental cash flow. Here are some of the challenges:

1. Sunk costs

Sunk costs are also known as past costs that have already been incurred. Incremental
cash flow looks into future costs; accountants need to make sure that sunk costs are not
included in the computation. This is especially true if the sunk cost happened before any
investment decision was made.

2. Opportunity costs

From the term itself, opportunity costs refer to a business’ missed chance for revenues
from its assets. They are often forgotten by accountants, as they do not include
opportunity costs in the computation of incremental cash flow.
One example is a company that specializes in sound system installations that skips a
project that requires the use of five sets of boom boxes. Currently, the business is only
putting the five extra sets of boom boxes in its storage facility, instead of taking on the
project that will earn $5,000. This illustrates the opportunity cost of $5,000.

3. Cannibalization

As mentioned above, cannibalization is the result of taking on a new project that reduces
the cash flow of another product or line of business. For example, an owner with an
existing mall that caters to classes A and B, and everything it sells is sold at a premium
because it caters to luxury shoppers.

In another part of the same city, it decides to open a new mall that caters to classes B, C,
and D, selling the same items as the other mall but at a significantly lower price. This will
result in cannibalization because some people will no longer go to the first mall because
they can get most things at the new mall for a much lower price.

4. Allocated costs

These are some costs that must be allocated to a specific department or project and there
may not be a rational way to do it (i.e. rent expense)..

Incremental Cash Flow vs. Total Cash Flow

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Incremental cash flow and total cash flow both deal with a business’ or project’s cash
flow. However, they are notably different from each other.

 Incremental cash flow analysis tries to predict the future cash flow of a business if
it takes on a new project. It helps management determine if a project is worth doing
or not. Projects will be considered if it is a positive incremental cash flow is
generated, and declined if negative cash flows are expected.

 Total cash flow analysis determines the total cumulative cash that’s been
generated from doing a project or evaluating a business. For example, when a
CEO wants to see the total cash flow of the company from each of the preceding
five years. To come up with the correct figure, all the cash flows from each year in
the last five years are put together.

Example of Asset Expansion

A project that requires a firm to invest funds in additional assets in order to increase sales
(or reduce costs) is called an asset expansion project. For example, suppose the TLC
Yogurt Company has decided to capitalize on the exercise fad and plans to open an
exercise facility in conjunction with its main yogurt and health foods store. To get the
project under way, the company will rent additional space adjacent to its current store.
The equipment required for the facility will cost $50,000.

Shipping and installation charges for the equipment are expected to total $5,000. This
equipment will be depreciated on a straight-line basis over its 5-year economic life to an
estimated salvage value of $0. In order to open the exercise facility, TLC estimates that it
will have to add about $7,000 initially to its net working capital in the form of additional
inventories of exercise supplies, cash, and accounts receivable for its exercise customers
(less accounts payable).

During the first year of operations, TLC expects its total revenues (from yogurt sales and
exercise services) to increase by $50,000 above the level that would have prevailed
without the exercise facility addition. These incremental revenues are expected to grow to
$60,000 in year 2, $75,000 in year 3, decline to $60,000 in year 4, and decline again to
$45,000 during the fifth and final year of the project’s life. The company’s incremental
operating costs associated with the exercise facility, including the rental of the facility, are
expected to total $25,000 during the first year and increase at a rate of 6 percent per year
over the 5-year project life.

Depreciation will be $11,000 per year ($55,000 installed cost, assuming no salvage value,
divided by the 5-year economic life). TLC has a marginal tax rate of 40 percent. In
addition, TLC expects that it will have to add about $5,000 per year to its net working
capital in years 1, 2, and 3 and nothing in years 4 and 5. At the end of the project, the
total accumulated net working capital required by the project will be recovered.

Calculating the Net Investment

First, we determine the net investment required for the exercise facility expansion. TLC
must make a cash outlay of $50,000 to pay for the facility equipment. In addition, it must

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pay $5,000 in cash to cover the costs of shipping and installation of the equipment.
Finally, TLC must invest $7,000 in initial net working capital to get the project under way.
The 4-step procedure discussed earlier for calculating the net investment yields the NINV
required at time 0:

Note that steps 3 and 4 are not required in this problem since this is an asset expansion
decision and no existing assets are being sold.

Calculating Annual Net Cash Flows

Next, we need to calculate the annual net cash flows associated with the project. The first
year net cash flows can be computed by substituting:

_R = $50,000, _O = $25,000, _Dep = $11,000, T = 0.40, and _NWC = $5,000 into

equation :

Year 1:

NCF1 = ($50,000 – $25,000 – $11,000) (1 – 0.40) + $11,000 – $5,000 = $14,400

A similar calculation for the second year, where _R = $60,000, _O = $25,000 (1 + 0.06)1
= $26,500, _Dep = $11,000, T = 0.40, and _NWC = $5,000, yields:

Year 2:

NCF2 = ($60,000 – $26,500 – $11,000) (1 – 0.40) + $11,000 – $5,000 = $19,500

Finally, in the fifth year, TLC will recover its working capital investment of $22,000, i.e.,
$7,000 (Year 0) and $5,000 (Years 1, 2, and 3). Substituting _NWC = –$22,000, along
with _R = $45,000 and _O = $25,000 (1 + 0.06)4 = $31,562, _Dep = $11,000, and T =
0.40 into Equation yields:

Year 5

NCF5 = ($45,000 – $31,562 – $11,000) (1 – 0.40) + $11,000 – (–$22,000) = $34,463

The calculations of annual cash flows for these years as well as for years 3 and 4 are
summarized in Table Note that since the equipment was fully depreciated and had no
salvage value at the end of the fifth year, the after-tax salvage value was $0. The cash
flows associated with the exercise facility project are illustrated with the time line in
Figure.

Example of Asset Replacement

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The previous example of an asset expansion project illustrated the key elements of the
calculation of a project’s net investment and its annual net cash flows. In this section, we
consider an asset replacement project. Asset replacements involve retiring one asset and
replacing it with a more efficient asset.

Suppose Briggs & Stratton purchased an automated drill press 10 years ago that had an
estimated economic life of 20 years. The drill press originally cost $150,000 and has been
fully depreciated, leaving a current book value of $0. The actual market value of this drill
press is $40,000. The company is considering replacing the drill press with a new one
costing $190,000.

Shipping and installation charges will add an additional $10,000 to the cost. The new
machine would be depreciated to zero on a straight-line basis. The new machine is
expected to have a 10 -year economic life, and its actual salvage value at the end of the
10 -year period is estimated to be $25,000. Briggs & Stratton’s current marginal tax rate is
40 percent.

Calculation of Annual Net Cash Flows for TLC Exercise Facility

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Estimated Cash Flows for TLC Investment Project

Calculating the Net Investment

Steps 1 and 2 of the net investment calculation are easy; the new project cost($190,000)
plus shipping and installation ($10,000) is $200,000. In this case, no initial incremental net
working capital is required. In steps 3 and 4, the net proceeds received from the sale of
the old drill press have to be adjusted for taxes.

Because the old drill press is sold for $40,000, the gain from this sale is treated as a
recapture of depreciation and thus taxed as ordinary income. Table summarizes the NINV
calculation for Briggs & Stratton. As can be seen in this table, the NINV is equal to
$176,000.

Calculating Annual Net Cash Flows

Suppose Briggs & Stratton expects annual revenues during the project’s first year to
increase from $70,000 to $85,000 if the new drill press is purchased. (This might occur
because the new press is faster than the old one and can meet the increasing demands
for more work.) After the first year, revenues from the new project are expected to
increase at a rate of $2,000 a year for the remainder of the project life.

Assume further that while the old drill press required two operators, the new drill press is
more automated and needs only one, thereby reducing annual operating costs from

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$40,000 to $20,000 during the project’s first year. After the first year, annual operating
costs of the new drill press are expected to increase by $1,000 a year over the remaining
life of the project. The old machine is fully depreciated, whereas the new machine will be
depreciated on a straight -line basis.

The marginal tax rate of 40 percent applies. Assume also that the company’s net working
capital does not change as a result of replacing the drill press. The first -year net cash
flow resulting from the purchase of the new drill press can be computed by substituting
Rw = $85,000,
Rwo = $70,000,
Ow = $20,000,
Owo = $40,000,
Depw = $20,000 ( = $200,000/10),
Depwo = $0,
T = 0.40, and
_NWC = $0 into Equation 9.3 as follows:

NCF1 = [($85,000 – $70,000) – ($20,000 – $40,000)– ($20,000 – $0)](1 – 0.4) + ($20,000

– $0) – $0 = $29,000

Using the different expected values for new revenues Rw = $87,000 and new operating
costs Ow = $21,000 in the second year, the second-year net cash flows can be computed
as follows:

Net Investment Calculation for Briggs & Stratton

Year 2:
NCF2 = [($87,000 – $70,000) – ($21,000 – $40,000)– ($20,000 – $0)](1 – 0.4) + ($20,000
- $0) – $0 = $29,600

Similar calculations are used to obtain the net cash flows in years 3 through 9.

Finally, in year 10, the $25,000 estimated salvage from the new drill press must be added
along with its associated tax effects. This $25,000 salvage is treated as ordinary income
because it represents a recapture of depreciation for tax purposes.

NCF10 = [($103,000 – $70,000) – ($29,000 – $40,000)– ($20,000 – $0)](1 – 0.4) +

($20,000 – $0) – $0 + $25,000 salvage – tax on salvage (0.4*$25,000) = $34,400 +

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$25,000 – $10,000 = $49,400

Table We shown here is a summary worksheet for computing the net cash flows for
Briggs & Stratton during the 10-year estimated economic life of the new drill press.

We shown summarizes the net cash flows for the entire project. This schedule of net cash
flows plus the NINV computed in the preceding section form the basis for further analysis.
several different capital budgeting decision models are applied to similar cash flow
streams from other projects to determine the investment desirability of these projects. The
cash flows developed in this chapter are an essential input in the capital budgeting
decision process.

LEARNING POINTS
 Capital budgeting is the process of analyzing and ranking proposed projects to
determine which ones are deserving of an investment. The result is intended to
be a high return on invested funds.
 There are three general methods for deciding which proposed projects should
be ranked higher than other projects, which are (in declining order of
preference):Throughput analysis, Discounted cash flow analysis, and Payback
analysis.
 There are several types of capital expenditures. These can be grouped
into projects generated by growth opportunities, projects generated by cost
reduction opportunities, and projects generated to meet legal requirements and
health and safety standards.
 Because cash flow is the lifeblood of any business, it should be under constant
review and optimization. Staying on top of cash projections, cash movement, and
your sources of cash is essential to avoid cash shortfalls. There are seven year-
end steps you should take to review your cash flow situation and plan for a cash
flow positive.
 The discounted after-tax cash flow method is an approach to valuing an
investment by assessing the amount of money generated and taking into account
the cost of capital along with the applicable marginal tax rate.
 Discounted after-tax cash flow is similar to simple discounted cash flow (DCF), but
here tax implications are also taken into consideration.
 Incremental cash flow refers to cash flow that a company acquires when it takes on
a new project. If you have a positive incremental cash flow, it means that your
company’s cash flow will increase after you accept it. That’s a good indicator that
it’s worth investing in a project. On the other hand, a negative incremental cash
flow indicates that your cash flow will decrease, which means that it may not be the
best option.
 A project that requires a firm to invest funds in additional assets in order to
increase sales (or reduce costs) is called an asset expansion project.
 On the other hand, Asset replacements involve retiring one asset and replacing it
with a more efficient asset.

LEARNING ACTIVITIES

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REFERENCES

1. https://www.accountingtools.com/articles/2017/5/17/overview-of-capital-budgeting
2. https://www.wisdomjobs.com/e-university/financial-management-tutorial-289/
generating-capital-investment-project-proposals-6604.html
3. https://fundbox.com/blog/7-step-end-of-year-cash-flow-checklist/
4. https://www.investopedia.com/terms/d/discounted-after-tax-cash-flow.asp
5. https://gocardless.com/guides/posts/what-is-incremental-cash-flow/
6. https://corporatefinanceinstitute.com/resources/knowledge/accounting/incremental-
cash-flow/
7. https://www.wisdomjobs.com/e-university/financial-management-tutorial-289/asset-
expansion-projects-6608.html
8. https://www.wisdomjobs.com/e-university/financial-management-tutorial-289/asset-
replacement-projects-6610.html

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