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Chapter10CapitalBudgetingandEstimatingCashFlowsAfterStudyingChapter10,youshouldbeableto:1.Definecapitalbudgetingandidentifythestepsinvolvedi

nthecapitalbudgetingprocess.2.Explaintheproceduretogeneratelong-termprojectproposalswithinthefirm.3.Justifywhycash,notincome,flowsare

themostrelevanttocapitalbudgetingdecisions.4.Definetheterms“sunkcost”and“opportunitycost”andexplainwhysunkcostsmustbeignored,whileoppo

rtunitycostsmustbeincluded,incapitalbudgetinganalysis.5.Determineinitial,interim,andterminalperiod“after-tax,incremen

tal,operatingcashflows”associatedwithacapitalinvestmentproject.CapitalBudgetingandEstimatingCashFlows•Th

eCapitalBudgetingProcess•GeneratingInvestmentProjectProposals•EstimatingProject“After-TaxIncrementalOperati

ngCashFlows”WhatisCapitalBudgeting?Theprocessofidentifying,analyzing,andselectinginvestmentprojectswhosereturns(cashflows)

areexpectedtoextendbeyondoneyear.TheCapitalBudgetingProcess•Generateinvestmentproposalsconsistentwiththefirm’sstrategicobjectives.•E

stimateafter-taxincrementaloperatingcashflowsfortheinvestmentprojects.•Evaluateprojectincrementalcashflows.TheCap

italBudgetingProcess•Selectprojectsbasedonavalue-maximizingacceptancecriterion.•Reevaluateimplementedinvestmentprojectscontinuallyandperformpostaudi

tsforcompletedprojects.ClassificationofInvestmentProjectProposals1.Newproductsorexpansionofexistingproducts2.Replacementofexistingequipm

entorbuildings3.Researchanddevelopment4.Exploration5.Other(e.g.,safetyorpollutionrelated)ScreeningProposalsandDecisionMaking

1.SectionChiefs2.PlantManagers3.VPforOperations4.CapitalExpendituresCommittee5.President6.BoardofDirectorsAdvancementtothenex

tleveldependsoncostandstrategicimportance.EstimatingAfter-TaxIncrementalCashFlows•Cash(notaccountingincome)flows•Operat

ing(notfinancing)flows•After-taxflows•IncrementalflowsBasiccharacteristicsofrelevantprojectflowsEstimatingAfter-TaxIncrementalCashFl

ows•Ignoresunkcosts•Includeopportunitycosts•Includeproject-drivenchangesinworkingcapitalnetofspontaneouschangesin

currentliabilities•IncludeeffectsofinflationPrinciplesthatmustbeadheredtointheestimationCalculatingtheIncrementalCashFlo

ws•Initialcashoutflow–theinitialnetcashinvestment.•Interimincrementalnetcashflows–thosenetcashflowsoccurringafte

rtheinitialcashinvestmentbutnotincludingthefinalperiod’scashflow.•Terminal-yearincrementalnetcashflows–thefinalperiod’snetcashflow.InitialCash

Outflowa)Costof“new”assetsb)+Capitalizedexpendituresc)+(–)Increased(decreased)NWCd)–Netproceedsfromsaleof“old”asset

(s)ifreplacemente)+(–)Taxes(savings)duetothesaleof“old”asset(s)ifreplacementf)=InitialcashoutflowIncrementalCashFlowsa)Netincr.(de

cr.)inoperatingrevenueless(plus)anynetincr.(decr.)inoperatingexpenses,excludingdepr.b)–(+)Netincr.(decr.)intaxdepreciationc)=Netch

angeinincomebeforetaxesd)–(+)Netincr.(decr.)intaxese)=Netchangeinincomeaftertaxesf)+(–)Netincr.(decr.)intaxdepr.chargesg)=Inc

rementalnetcashflowforperiodTerminal-YearIncrementalCashFlowsa)Calculatetheincrementalnetcashflowfortheterminalperiodb)+(–)Salvagevalue(disposa

l/reclamationcosts)ofanysoldordisposedassetsc)–(+)Taxes(taxsavings)duetoassetsaleordisposalof“new”assetsd)

+(–)Decreased(increased)levelof“net”workingcapitale)=TerminalyearincrementalnetcashflowExampleofanAssetExpansionProjectBasketWonders(BW

)isconsideringthepurchaseofanewbasketweavingmachine.Themachinewillcost$50,000plus$20,000forshippingandinstallationandfallsunderthe3-yearMACRSclas

s.NWCwillriseby$5,000.LisaMillerforecaststhatrevenueswillincreaseby$110,000foreachofthenext4yearsandwillthenbesold(scrapped)for$10,000attheendofthef

ourthyear,whentheprojectends.Operatingcostswillriseby$70,000foreachofthenextfouryears.BWisinthe40%taxbracket.InitialCashOutflowa)$50,000

b)+20,000c)+5,000d)–0(notareplacement)e)+(–)0(notareplacement)f)=$75,000**Notethatwehavecalculatedthisvalueasa“positive”becauseitisacashOUTFLOW(nega

tive).IncrementalCashFlowsYear1Year2Year3Year4a)$40,000$40,000$40,000$40,000b)–23,33131,11510,3675,187c)=$16,669$8,885$29,633$34,813d

)–6,6683,55411,85313,925e)=$10,001$5,331$17,780$20,888f)+23,33131,11510,3675,187g)=$33,332$36,446$28,147$26,075Terminal-Year

IncrementalCashFlowsa)$26,075TheincrementalcashflowfromthepreviousslideinYear4.b)+10,000SalvageValue.c)–4,000

.40*($10,000-0)Note,theassetisfullydepreciatedattheendofYear4.d)+5,000NWC-Projectends.e)=$37,075Terminal-yearinc

rementalcashflow.SummaryofProjectNetCashFlowsAssetExpansionYear0Year1Year2Year3Year4–$75,000*$33,332$36,4

46$28,147$37,075*NoticeagainthatthisvalueisanegativecashflowaswecalculateditastheinitialcashOUTFLOWb

efore.