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Chapter10CapitalBudgetingandEstimatingCashFlowsAfterStudyingChapter10,youshouldbeableto:1.Definecapitalbudget

ingandidentifythestepsinvolvedinthecapitalbudgetingprocess.2.Explaintheproceduretogeneratelong-termprojectprop

osalswithinthefirm.3.Justifywhycash,notincome,flowsarethemostrelevanttocapitalbudgetingdecisions.4.Definetheterms“sunkcost”and“opp

ortunitycost”andexplainwhysunkcostsmustbeignored,whileopportunitycostsmustbeincluded,incapitalbudgetinganalysis.5.Determineinitial,inter

im,andterminalperiod“after-tax,incremental,operatingcashflows”associatedwithacapitalinvestmentproject.CapitalBudgetingandE

stimatingCashFlows•TheCapitalBudgetingProcess•GeneratingInvestmentProjectProposals•EstimatingProject“After-TaxI

ncrementalOperatingCashFlows”WhatisCapitalBudgeting?Theprocessofidentifying,analyzing,andselectinginvestmentprojectswhosereturns(cashflow

s)areexpectedtoextendbeyondoneyear.TheCapitalBudgetingProcess•Generateinvestmentproposalsconsistentwiththefirm’sstrategicobjectives.•Estimate

after-taxincrementaloperatingcashflowsfortheinvestmentprojects.•Evaluateprojectincrementalcashflows.The

CapitalBudgetingProcess•Selectprojectsbasedonavalue-maximizingacceptancecriterion.•Reevaluateimplementedinvestmentprojectscontinuallyandperformpost

auditsforcompletedprojects.ClassificationofInvestmentProjectProposals1.Newproductsorexpansionofexistingproducts2.Replacementofexistin

gequipmentorbuildings3.Researchanddevelopment4.Exploration5.Other(e.g.,safetyorpollutionrelated)ScreeningProposalsandDecisionMaking1.Sectio

nChiefs2.PlantManagers3.VPforOperations4.CapitalExpendituresCommittee5.President6.BoardofDirectorsAdvancementtothenextleveld

ependsoncostandstrategicimportance.EstimatingAfter-TaxIncrementalCashFlows•Cash(notaccountingincome)flows•Operating(notfinancing)flows•

After-taxflows•IncrementalflowsBasiccharacteristicsofrelevantprojectflowsEstimatingAfter-TaxIncrementalCashFlows•Ignoresu

nkcosts•Includeopportunitycosts•Includeproject-drivenchangesinworkingcapitalnetofspontaneouschangesincurrentliabilities•Includeeffect

sofinflationPrinciplesthatmustbeadheredtointheestimationCalculatingtheIncrementalCashFlows•Initialcashoutflow–theinitialnet

cashinvestment.•Interimincrementalnetcashflows–thosenetcashflowsoccurringaftertheinitialcashinvestmentbutnotincludingthefinalp

eriod’scashflow.•Terminal-yearincrementalnetcashflows–thefinalperiod’snetcashflow.InitialCashOutflowa)Costof“new”assetsb)+Capitalizedexpendi

turesc)+(–)Increased(decreased)NWCd)–Netproceedsfromsaleof“old”asset(s)ifreplacemente)+(–)Taxes(savings)duetothesaleof“old”asset(s

)ifreplacementf)=InitialcashoutflowIncrementalCashFlowsa)Netincr.(decr.)inoperatingrevenueless(plus)anynetincr.(decr.)inoperatingexpens

es,excludingdepr.b)–(+)Netincr.(decr.)intaxdepreciationc)=Netchangeinincomebeforetaxesd)–(+)Netincr.(decr.)intaxese)=Netchangeinincomeaft

ertaxesf)+(–)Netincr.(decr.)intaxdepr.chargesg)=IncrementalnetcashflowforperiodTerminal-YearIncrementalCashFlowsa)Calculatet

heincrementalnetcashflowfortheterminalperiodb)+(–)Salvagevalue(disposal/reclamationcosts)ofanysoldordisposedassetsc)–(+)Taxes(taxsavings)duetoassets

aleordisposalof“new”assetsd)+(–)Decreased(increased)levelof“net”workingcapitale)=TerminalyearincrementalnetcashflowExampl

eofanAssetExpansionProjectBasketWonders(BW)isconsideringthepurchaseofanewbasketweavingmachine.Themachinewillcost

$50,000plus$20,000forshippingandinstallationandfallsunderthe3-yearMACRSclass.NWCwillriseby$5,000.LisaMillerforecaststhatrevenues

willincreaseby$110,000foreachofthenext4yearsandwillthenbesold(scrapped)for$10,000attheendofthefourthyear,whentheprojectends.Operatingcostswillriseby$

70,000foreachofthenextfouryears.BWisinthe40%taxbracket.InitialCashOutflowa)$50,000b)+20,000c)+5,000d)–0(notareplacement)e)+(–)0(notar

eplacement)f)=$75,000**Notethatwehavecalculatedthisvalueasa“positive”becauseitisacashOUTFLOW(negative).IncrementalCashFlowsYear1Year2Y

ear3Year4a)$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-YearIncrementalCashFlowsa)$26,075Theincrementa

lcashflowfromthepreviousslideinYear4.b)+10,000SalvageValue.c)–4,000.40*($10,000-0)Note,theassetisfullydepreciatedattheendofYear4.d)+5,000NWC-P

rojectends.e)=$37,075Terminal-yearincrementalcashflow.SummaryofProjectNetCashFlowsAssetExpansionYear0Year1Year2Year3Year4–$75,000*$33,332$36,446$28,1

47$37,075*NoticeagainthatthisvalueisanegativecashflowaswecalculateditastheinitialcashOUTFLOWbefore.