Budgeting

Chapter 12
Cash Flow Estimation

Capital Budgeting: The process of planning
for purchases of long-term assets.
For example: Our firm must decide whether

to purchase a new plastic molding machine
for $127,000. How do we decide?
 The relevant project information follows:
 The cost of the new machine is $127,000.
 Installation will cost $20,000.
 $4,000 in net working capital will be needed at
the time of installation.
 The project will increase revenues by $85,000 per
year, but operating costs will increase by 35% of
the revenue increase.
 Simplified straight line depreciation is used.
 Class life is 5 years, and the firm is planning to
keep the project for 5 years.
 Salvage value at the end of year 5 will be $50,000.
 14% cost of capital; 34% marginal tax rate.
Capital Budgeting Steps
1) Evaluate Cash Flows
Look at all incremental cash flows
occurring as a result of the project.
 Initial outlay
 Differential Cash Flows over the life
of the project (also referred to as
annual cash flows).
 Terminal Cash Flows
1) Evaluate Cash Flows
Initial Terminal
outlay Cash flow
0 1 2 3 4 5 6 ... n
Annual Cash Flows

2) Evaluate the Risk of the Project

 We’ll get to this in the next chapter.
 For now, we’ll assume that the risk of the
project is the same as the risk of the
overall firm.
 If we do this, we can use the firm’s cost of
capital as the discount rate for capital
investment projects.
3) Accept or Reject the Project

Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
“time 0?”
(Purchase price of the asset)

+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
 a) Initial Outlay: What is the cash flow at
“time 0?”
(127,000) Purchase price of asset

+ (20,000) Shipping and installation
(147,000) Depreciable asset
+ (4,000) Net working capital
+ 0 Proceeds from sale of old asset
($151,000) Net initial outlay
b) Annual Cash Flows: What
incremental cash flows occur over the
life of the project?
For Each Year, Calculate:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
For Years 1 - 5:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
For Years 1 - 5:
85,000 Revenue
(29,750) Costs
(29,400) Depreciation
25,850 EBT
(8,789) Taxes
17,061 EAT
29,400 Depreciation reversal
46,461 = Annual Cash Flow
c) Terminal Cash Flow: What is the cash

flow at the end of the project’s life?
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow

50,000 Salvage value

Terminal Cash Flow
Tax Effects of Sale of Asset:
 Salvage value = $50,000.
 Book value = depreciable asset - total
amount depreciated.
 Book value = $147,000 - $147,000
= $0.
 Capital gain = SV - BV
= 50,000 - 0 = $50,000.
 Tax payment = 50,000 x .34 = ($17,000).


(17,000) Tax on capital gain
4,000 Recapture of NWC
37,000 Terminal Cash Flow
Project NPV:
 CF(0) = -151,000.
 CF(1 - 4) = 46,461.
 CF(5) = 46,461 + 37,000 = 83,461.
 Discount rate = 14%.
 NPV = $27,721.
 We would accept the project.
Practice Problems:
Cash Flows & Other Topics
in Capital Budgeting
Project Information: Problem 1a
 Cost of equipment = $400,000.
 Shipping & installation will be $20,000.
 $25,000 in net working capital required at setup.
 3-year project life, 5-year class life.
 Simplified straight line depreciation.
 Revenues will increase by $220,000 per year.
 Defects costs will fall by $10,000 per year.
 Operating costs will rise by $30,000 per year.
 Salvage value after year 3 is $200,000.
 Cost of capital = 12%, marginal tax rate = 34%.
Problem 1a
Initial Outlay:
(400,000) Cost of asset

+ ( 20,000) Shipping & installation
+ ( 25,000) Investment in NWC
($445,000) Net Initial Outlay
For Years 1 - 3: Problem 1a
220,000 Increased revenue
10,000 Decreased defects
(30,000) Increased operating costs
(84,000) Increased depreciation
116,000 EBT
(39,440) Taxes (34%)
76,560 EAT
Problem 1a
Terminal Cash Flow:
Salvage value
Terminal Cash Flow
Problem 1a
Terminal Cash Flow:

amount depreciated.
 Book value = $168,000.
 Capital gain = SV - BV = $32,000.
 Tax payment = 32,000 x .34 = ($10,880).
Problem 1a
Terminal Cash Flow:

Problem 1a Solution
NPV and IRR:

 CF(0) = -445,000
 CF(1 ), (2), = 160,560
 CF(3 ) = 160,560 + 214,120 = 374,680
 Discount rate = 12%
 IRR = 22.1%
 NPV = $93,044. Accept the project!
Problem 1b
Project Information:
 For the same project, suppose we
can only get $100,000 for the old
equipment after year 3, due to
rapidly changing technology.
 Calculate the IRR and NPV for the
project.
 Is it still acceptable?
Problem 1b
Terminal Cash Flow:
Salvage value
Terminal Cash Flow
Problem 1b
Terminal Cash Flow:

amount depreciated.
 Book value = $168,000.
 Capital loss = SV - BV = ($68,000).
 Tax refund = 68,000 x .34 = $23,120.
Problem 1b
Terminal Cash Flow:

23,120 Tax on capital gain
Problem 1b Solution
NPV and IRR:

 CF(0) = -445,000.
 CF(1), (2) = 160,560.
 CF(3) = 160,560 + 148,120 = 308,680.
 IRR = 17.3%.
 NPV = $46,067. Accept the project!
Automation Project: Problem 2
 Cost of equipment = $550,000.
 $15,000 in net working capital required at setup.
 Current operating expenses are $640,000 per yr.
 New operating expenses will be $400,000 per yr.
 Already paid consultant $25,000 for analysis.
Problem 2
Initial Outlay:
(550,000) Cost of new machine

+ (25,000) Shipping & installation
+ (15,000) NWC investment
(590,000) Net Initial Outlay
For Years 1 - 5: Problem 2
240,000 Cost decrease

(115,000) Depreciation increase
125,000 EBIT
(42,500) Taxes (34%)
82,500 EAT
Problem 2
For Years 6 - 8:
240,000 Cost decrease

( 0) Depreciation increase
240,000 EBIT
(81,600) Taxes (34%)
158,400 EAT
0 Depreciation reversal
Problem 2
Terminal Cash Flow:

Problem 2 Solution
NPV and IRR:

 CF(0) = -590,000.
 CF(1 - 5) = 197,500.
 CF(6 - 7) = 158,400.
 CF(10) = 158,400 + 41,400 = 199,800.
 IRR = 28.13% NPV = $293,543.
 We would accept the project!
Problem 3
Replacement Project:
Old Asset (5 years old):

 Cost of equipment = $1,125,000.
 Current salvage value is $400,000.
 Cost of capital = 14%, marginal tax
rate = 35%.
Replacement Project: Problem 3
New Asset:
 Cost of equipment = $1,750,000.
 $68,000 investment in net working capital.
 Will increase sales by $285,000 per year.
 Operating expenses will fall by $100,000 per year.
 Already paid $15,000 for training program.
Problem 3: Sell the Old Asset
amount depreciated.
 Book value = $1,125,000 - $562,500
= $562,500.
 Capital gain = SV - BV
= 400,000 - 562,500 = ($162,500).
 Tax refund = 162,500 x .35 = $56,875.
Problem 3
Initial Outlay:
(1,750,000)Cost of new machine

+ ( 56,000) Shipping & installation
(1,806,000)Depreciable asset
+ ( 68,000) NWC investment
+ 456,875 After-tax proceeds (sold
old machine)
(1,417,125) Net Initial Outlay
Problem 3
For Years 1 - 5:
385,000 Increased sales & cost savings

(248,700) Extra depreciation
136,300 EBT
(47,705) Taxes (35%)
88,595 EAT
337,295 = Differential Cash Flow
Problem 3
Terminal Cash Flow:

Problem 3 Solution
NPV and IRR:

 CF(0) = -1,417,125.
 CF(1 - 4) = 337,295.
 CF(5) = 337,295 + 393,000 = 730,295.
 NPV = (55,052.07).
 IRR = 12.55%.
 We would not accept the project!

Budgeting

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Chapter 12

Cash Flow Estimation

For example: Our firm must decide whether

Annual Cash Flows

2) Evaluate the Risk of the Project

3) Accept or Reject the Project

(Purchase price of the asset)

(127,000) Purchase price of asset

c) Terminal Cash Flow: What is the cash

c) Terminal Cash Flow: What is the cash

50,000 Salvage value

c) Terminal Cash Flow: What is the cash

50,000 Salvage value

(400,000) Cost of asset

 Salvage value = $200,000.

Terminal Cash Flow:

200,000 Salvage value

NPV and IRR:

Terminal Cash Flow:

 Salvage value = $100,000.

Terminal Cash Flow:

100,000 Salvage value

NPV and IRR:

(550,000) Cost of new machine

240,000 Cost decrease

240,000 Cost decrease

40,000 Salvage value

NPV and IRR:

Old Asset (5 years old):

(1,750,000)Cost of new machine

385,000 Increased sales & cost savings

500,000 Salvage value

NPV and IRR:

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