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Chapter10CapitalBudgetingandEstimatingCashFlowsAfterStudyingChapter10,youshouldbeableto:1.Definecapitalbudgetingandidenti

fythestepsinvolvedinthecapitalbudgetingprocess.2.Explaintheproceduretogeneratelong-termprojectproposa

lswithinthefirm.3.Justifywhycash,notincome,flowsarethemostrelevanttocapitalbudgetingdecisions.4.Definetheterms“sunkcost”and“oppor

tunitycost”andexplainwhysunkcostsmustbeignored,whileopportunitycostsmustbeincluded,incapitalbudgetinganalysis.5.Determineinitial,interim,andtermina

lperiod“after-tax,incremental,operatingcashflows”associatedwithacapitalinvestmentproject.CapitalBudg

etingandEstimatingCashFlows•TheCapitalBudgetingProcess•GeneratingInvestmentProjectProposals•EstimatingProject“After-

TaxIncrementalOperatingCashFlows”WhatisCapitalBudgeting?Theprocessofidentifying,analyzing,andselectinginvestme

ntprojectswhosereturns(cashflows)areexpectedtoextendbeyondoneyear.TheCapitalBudgetingProcess•Generateinvestmentproposalsconsistentw

iththefirm’sstrategicobjectives.•Estimateafter-taxincrementaloperatingcashflowsfortheinvestmentprojects.•Evalu

ateprojectincrementalcashflows.TheCapitalBudgetingProcess•Selectprojectsbasedonavalue-maximizingacceptancecriterion.•Reevaluateimplemente

dinvestmentprojectscontinuallyandperformpostauditsforcompletedprojects.ClassificationofInvestmentProjectProposals

1.Newproductsorexpansionofexistingproducts2.Replacementofexistingequipmentorbuildings3.Researchanddevelopmen

t4.Exploration5.Other(e.g.,safetyorpollutionrelated)ScreeningProposalsandDecisionMaking1.SectionChiefs2.PlantManagers3.VPforOperations4.CapitalEx

pendituresCommittee5.President6.BoardofDirectorsAdvancementtothenextleveldependsoncostandstrategicimportance.EstimatingAfter-Tax

IncrementalCashFlows•Cash(notaccountingincome)flows•Operating(notfinancing)flows•After-taxflows•Incrementalfl

owsBasiccharacteristicsofrelevantprojectflowsEstimatingAfter-TaxIncrementalCashFlows•Ignoresunkcosts•Includeopportu

nitycosts•Includeproject-drivenchangesinworkingcapitalnetofspontaneouschangesincurrentliabilities•IncludeeffectsofinflationPrinciplestha

tmustbeadheredtointheestimationCalculatingtheIncrementalCashFlows•Initialcashoutflow–theinitialnetcashinvestment.•Interimincrementalnetcashflow

s–thosenetcashflowsoccurringaftertheinitialcashinvestmentbutnotincludingthefinalperiod’scashflow.•Terminal-yearincrementalne

tcashflows–thefinalperiod’snetcashflow.InitialCashOutflowa)Costof“new”assetsb)+Capitalizedexpenditur

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

leof“old”asset(s)ifreplacementf)=InitialcashoutflowIncrementalCashFlowsa)Netincr.(decr.)inoperatingrevenueless(plus)anynetincr.(decr.)inoperati

ngexpenses,excludingdepr.b)–(+)Netincr.(decr.)intaxdepreciationc)=Netchangeinincomebeforetaxesd)–(+)Netincr.(decr.)intaxese)=Netchangeinincomeafterta

xesf)+(–)Netincr.(decr.)intaxdepr.chargesg)=IncrementalnetcashflowforperiodTerminal-YearIncrementalCashFlowsa)Calculatetheincrementalnetcashf

lowfortheterminalperiodb)+(–)Salvagevalue(disposal/reclamationcosts)ofanysoldordisposedassetsc)–(+)Taxes(taxsavings)duetoasset

saleordisposalof“new”assetsd)+(–)Decreased(increased)levelof“net”workingcapitale)=TerminalyearincrementalnetcashflowExampleofanAsset

ExpansionProjectBasketWonders(BW)isconsideringthepurchaseofanewbasketweavingmachine.Themachinewillcost$50,000plus$20,000forship

pingandinstallationandfallsunderthe3-yearMACRSclass.NWCwillriseby$5,000.LisaMillerforecaststhatrevenueswillincreaseby$110,

000foreachofthenext4yearsandwillthenbesold(scrapped)for$10,000attheendofthefourthyear,whentheprojectends.O

peratingcostswillriseby$70,000foreachofthenextfouryears.BWisinthe40%taxbracket.InitialCashOutflowa)$50,000

b)+20,000c)+5,000d)–0(notareplacement)e)+(–)0(notareplacement)f)=$75,000**Notethatwehavecalculatedthisvalue

asa“positive”becauseitisacashOUTFLOW(negative).IncrementalCashFlowsYear1Year2Year3Year4a)$40,000$40,000$4

0,000$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)$26,075Theincrementalcashflowfromthepre

viousslideinYear4.b)+10,000SalvageValue.c)–4,000.40*($10,000-0)Note,theassetisfullydepreciatedattheendofYear4.d)+5,000NWC-Proj

ectends.e)=$37,075Terminal-yearincrementalcashflow.SummaryofProjectNetCashFlowsAssetExpansionYear0Year1Year2Year3Year4–$75,000*$33,3

32$36,446$28,147$37,075*NoticeagainthatthisvalueisanegativecashflowaswecalculateditastheinitialcashOUTFLOWbefore.