This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
After Studying Chapter 12, After Studying Chapter 12, you should be able to:you should be able to:
1. Define capital budgeting and identify the steps involved in the capital budgeting process.
2. Explain the procedure 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, while opportunity costs must be included, in capital budgeting analysis.
6. Explain how tax considerations, as well as depreciation for tax purposes, affects capital budgeting cash flows.
7. Determine initial, interim, and terminal period “after-tax, incremental, operating cash flows” associated with a capital investment project.
Tax Considerations Tax Considerations and Depreciationand Depreciation
• Generally, profitable firms prefer to use an accelerated method for tax reporting purposes (MACRS).
• DepreciationDepreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both.
Sale or Disposal of Sale or Disposal of a Depreciable Asseta Depreciable Asset
• Often historically, capital gains income has received more favorable US tax treatment than operating income.
• Generally, the sale of a “capital asset” (as defined by the IRS) generates a capital gain (asset sells for more than book value) or capital loss (asset sells for less than book value).
Calculating the Calculating the Incremental Cash FlowsIncremental Cash Flows
• Initial cash outflow Initial cash outflow – the initial net cash investment.
• Interim incremental net cash flows Interim incremental net cash flows – those net cash flows occurring after the initial cash investment but not including the final period’s cash flow.
• Terminal-year incremental net cash Terminal-year incremental net cash flows flows – the final period’s net cash flow.
Initial Cash OutflowInitial Cash Outflowa) Cost of “new” assetsCost of “new” assetsb) + Capitalized expendituresc) + (–) Increased (decreased) NWCd) – Net proceeds from sale of “old”
asset(s) if replacemente) + (–) Taxes (savings) due to the sale
of “old” asset(s) if replacementf) == Initial cash Initial cash outflowoutflow
Incremental Cash FlowsIncremental Cash Flowsa) Net incr. (decr.) in operating
revenue less (plus) any net incr. (decr.) in operating expenses, excluding depr.
b) – (+) Net incr. (decr.) in tax depreciationc) = Net change in income before taxesd) – (+) Net incr. (decr.) in taxese) = Net change in income after taxesf) + (–) Net incr. (decr.) in tax depr.
chargesg) == Incremental net cash flow for Incremental net cash flow for
Example of an Asset Example of an Asset Expansion ProjectExpansion Project
Basket Wonders (BW) is considering the purchase of a new basket weaving machine. The
machine will cost $50,000 plus $20,000 for shipping and installation and falls under the 3-
year MACRS class. NWC will rise by $5,000. Lisa Miller forecasts that revenues will increase by $110,000 for each of the next 4 years and will
then be sold (scrapped) for $10,000 at the end of the fourth year, when the project ends. Operating costs will rise by $70,000 for each of the next four
RememberRemember, you can use , you can use Excel - Very Valuable!!Excel - Very Valuable!!
Refer to the spreadsheet
‘VW13E-12b.xlsx’ on
the ‘New Asset’ tab for
this spreadsheet.
Try changing Try changing information in information in
the the spreadsheet spreadsheet
to see the to see the impact!impact!
New Asset Cost: 50,000$ Old Asset current market value: -$ Capitalized Expenditures: 20,000$ Old' Asset current book value: -$
Initial Net Working Capital: 5,000$
1 2 3 4 Remaining Depreciation at end of period 423,331$ 31,115$ 10,367$ 5,187$ -$
-$ -$ -$ -$ 23,331$ 31,115$ 10,367$ 5,187$
ICONew Asset Cost: 50,000$
Capitalized Expenditures: 20,000$ Initial Net Working Capital: 5,000$
Proceeds from sale of 'old' assets: -$ No need on a NEW asset, so $0 valueTax on proceeds relative to book value: -$ No need on a NEW asset, so $0 value
75,000$
Δ in oper revenue: 110,000$ Δ in oper expense: 70,000$
Tax rate: 40%
0 1 2 3 4Δ in oper revenue - Δ in oper expense: 40,000$ 40,000$ 40,000$ 40,000$
subtract Δ in depreciation: 23,331$ 31,115$ 10,367$ 5,187$ 0 (75,000)$ equals Δ in income before taxes: 16,669$ 8,885$ 29,633$ 34,813$ 1 33,332$
subtract Δ in taxes: 6,668$ 3,554$ 11,853$ 13,925$ 2 36,446$ equals Δ in income after taxes: 10,001$ 5,331$ 17,780$ 20,888$ 3 28,147$
add back non-cash Δ in depreciation: 23,331$ 31,115$ 10,367$ 5,187$ 4 37,075$ Incremental cash flow: 33,332$ 36,446$ 28,147$ 26,075$
Capitalized Expenditures: 20,000$ Initial Net Working Capital: 5,000$
Proceeds from sale of 'old' assets: 6,000$ No need on a NEW asset, so $0 valueTax on proceeds relative to book value: (2,400)$ No need on a NEW asset, so $0 value
66,600$
Δ in oper revenue: -$ <== both are at $110,000Δ in oper expense: (10,000)$ <== oper expenses reduced from $80K to $70K
Tax rate: 40%
0 1 2 3 4Δ in oper revenue - Δ in oper expense: 10,000$ 10,000$ 10,000$ 10,000$
subtract Δ in depreciation: 17,331$ 25,115$ 10,367$ 5,187$ 0 (66,600)$ equals Δ in income before taxes: (7,331)$ (15,115)$ (367)$ 4,813$ 1 12,932$
subtract Δ in taxes: (2,932)$ (6,046)$ (147)$ 1,925$ 2 16,046$ equals Δ in income after taxes: (4,399)$ (9,069)$ (220)$ 2,888$ 3 10,147$
add back non-cash Δ in depreciation: 17,331$ 25,115$ 10,367$ 5,187$ 4 19,075$