Capital Budgeting Chapter 11 273 | Page Since a firm’s investments involve large cash outlays and the amount of time involved is long, a firm has to find profitable project by using a well- developed evaluation process. Learning objectives After learning this chapter, you should be able to: 1. Define capital budgeting 2. Evaluate proposals according to respective capital budgeting techniques 3. Select the best proposal Capital Budgeting GOAL
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Capital Budgeting Chapter 11
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Since a firm’s investments involve large cash outlays
and the amount of time involved is long, a firm has to
find profitable project by using a well- developed
evaluation process.
Learning objectives
After learning this chapter, you should be able to:
1. Define capital budgeting
2. Evaluate proposals according to respective capital budgeting
techniques
3. Select the best proposal
Capital Budgeting
GOAL
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11.0 INTRODUCTION Capital budgeting is in essence similar to cost-benefit analysis that involves comparison of
expected returns generated and the costs incurred. It involves the whole process of planning
for capital investment or fixed assets, with the expectation of future cash flows beyond one-
year period. Capital investment or capital expenditures may consist of the following
expenditures:
1. Replacement of existing facilities;
2. Expansion of current facilities;
3. Safety and/or environmental projects; and
4. Any other expenditure that affects the firm's cash flow beyond one-year period.
The process of capital budgeting involves measuring the incremental cash flows associated
with the investment proposal and evaluating its attractiveness relative to the costs of the
project. Therefore, it is the process of:
1. Estimating the cash flows after tax generated from the investment;
2. Estimating the level of risk associated with the project; and
3. Employing ways or methods to evaluate the proposed project(s); and
4. Making effective decision to ensure it has a positive contribution to the firm's value.
Proper estimations and evaluations are necessary because it is costly to reverse any capital
decisions made and to ensure the firm's viability. Thus, this chapter will present the process
of estimating the cash flows from capital investment and several capital budgeting
techniques that are commonly used for project's evaluation under: (1) non discounted cash
flows method; and (2) discounted cash flows method. These techniques will enable the
financial managers to identify and choose capital investments that are viable and profitable
for the firm to venture into.
11.1 ESTIMATION OF CASH FLOW Estimation of cash flows associated with the project over its useful life is the first and utmost
important step in capital budgeting process to evaluate the proposed project. The accuracy
of the estimation is crucial, as it will affect the decisions made by the financial manager. The
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focus is on after tax cash flows, whether earnings after taxes (EAT) or cash flows after tax (CFAT). Cash flow after tax equals to:
CFATt = EATt + Non cash expenses for the period
In an attempt to estimate cash flows associated with capital investment, explicit
considerations should be given to its amount, timing and appropriate tax treatments. Note
however, the cost of interests or financing costs for the proposed project should be ignored,
as its implications will take in form of discount rate or required rate of return in the capital
budgeting process. Cash flows after taxes consist of three components that are net initial
cash flows, net annual cash flows, and terminal cash flows.
a) Net Initial Cash Flows (NICF)
Net initial cash flows are the initial investment or initial outlay, associated with the
initial cost of implementing the proposed capital project. It represents the net outflows
incurred to implement a proposed capital project at time zero; that is CFAT0.
Outflows:
1. Cost of equipment and facilities acquired.
2. All cost related to the acquisitions, transportation, and legal fees, training,
spare parts and installations.
3. Other tangible or intangible assets acquired.
4. Additional requirement for net working capital.
5. Tax liability on disposed assets; sold above the book value.
Inflows:
1. Investments tax credit, if any.
2. Proceeds from disposal of old assets.
3. Tax shield on disposed assets; sold less than the book value.
Not all of the listing above is applicable in all capital budgeting analysis, but any cash
outflows and inflows associated with the initial set up of the capital investment must
be considered, explicitly.
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b) Net Annual Cash Flows (NACF)
Net annual cash flows are the net cash inflows from expanded operations or the net
cash outflows saved from cost reduction projects. NACF also referred as operating cash flows which occur at time (t) through (n), CFATt; that is from year one through
n years of the project's life.
CFBTt : Cash inflowst minus Cash outflowst; excluding taxes and depreciation
It is also known as Cash Flows before Depreciation and Taxes (CFBDT)
T : Marginal corporate tax rate
Dept : Depreciation expenses for year t
∆ : Refer to incremental change
The NACF requires different treatments when dealing with expansion and
replacement capital investments. The basic determination CFAT is similar, except
that incremental cash flows must be used in determining CFATt of capital
investments that involve replacement. The calculations of CFAT under the tax shield
approach are as follows:
Operating cash flows for expansions project:
CFATt = CFBTt(1 – T) + Dept(T)
Operating cash flows for replacement project:
∆CFATt = ∆CFBTt(1 – T) + ∆Dept(T)
Where ∆ represent the incremental or change in cash flows. It is determined
by deducting the present cash flows from the expected cash flows due to the
replacements.
Both of the above equations assume that the firm is profitable. In the event the firm is
operating at a loss and where there is no tax liability, depreciation tax shield (=CFATt
(T)) does not exist.
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c) Terminal Cash Flows (TCF)
Terminal cash flows refer to the terminal value associated with the net cash inflows
realized in disposed asset. It represents the end value of a given asset at the end of
its economic life or end of usage due to disposal for replacement. Thus, CFATn of the
project are as follows:
Inflows:
1. Proceeds from the sale of assets.
2. Recovery of net working capital initially required.
3. Tax shields from the sale of assets; sold for less than book value
Outflows:
1. Cost of disposing the assets.
2. Tax liability from the sale of assets; sold above the book value.
The most commonly used term for terminal cash flows is salvage value. However, it
only refers to the expected book value of the assets at the end of its usage (end of
life or for disposal); without consideration of tax effects and other cash flow
associated with its disposal.
In the following sections, a sample of expansion and replacement projects will be
discussed starting from the determination of relevant cash flows and its application in
capital budgeting process. In most cases, the decision to accept or reject a particular
project will be based on the net present value method, since its measure is superior
to others for reasons mentioned earlier.
d) Example for Expansion Decisions
To illustrate, Zaza Products Inc. is considering an investment in a new computerized
machine to expand its production facilities that could increase sales and revenues.
The new machine has a 5-year useful life with a price tag of RM49,000. In addition,
freight and installation costs are RM1,000 and the increase in net working capital of
RM10,000 can be expected. This is due to additional requirements in accounts
receivable and inventory investment.
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The project is expected to generate additional cash flows of RM30,000 per year over
its useful life. The firm will also incurs additional cash outflows of RM5,000 per year
for the first three years, and the cost is expected to increase RM1,000 per year
thereafter as the machine wears out. Currently, the firm's marginal tax rate is 40%
and all assets are depreciated based on the straight-line method (SLM). There is no
salvage value expected at the end of 5 years. The determination of NACF requires
more than one calculation due to changes in cash outflows, and hence cash flows
before tax.
1. Net Initial Investment at year 0 or NICF: CFAT0
Purchase price 49,000
Plus: Freight and installation 1,000
Increase in net working capital 10,000
NICF or CFAT0 60,000
2. Operating Cash Flows in Years 1-5 or NACF1-5: CFAT1-5
CFAT1-3 = CFBTt (1 – T) + Dept (T)
= (30,000 – 5,000)(1 – 0.40) + (50,000 / 5)(0.40)
= RM19,000
Note that CFAT for year 1 through 3 is constant as it has the same CFBT and
Depreciation. However, CFAT for year 4 and 5 must be calculated
individually, as its CFBT are not the same.
CFAT4 = CFBT4 (1 – T) + Dep4 (T)
= (30,000 – 6,000)(1 – 0.40) + 10,000(0.40)
= RM18,400
CFAT5 = CFBT5 (1 – T) + Dep5 (T)
= (30,000 – 7,000)(1 – 0.40) + 10,000(0.40)
= RM17,800
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Another method to determine the CFAT is by using the income statement
format or the bottom up approach that uses the basic equation for CFAT, that
is:
CFATt = EATt + Depreciation
It will result in similar answers but with multiple stages of calculations as
shown in Table 11-1.
Table 11-1 Determination of CFAT under Bottom Up Approach
CFAT1-3 FATt CFAT5
Sales 30,000 30,000 30,000
Less: Cost of Goods Sold 5,000 6,000 7,000
Gross Profit 25,000 24,000 23,000
Less: Other costs - - -
Depreciation 10,000 10,000 10,000
Operating profit or EBIT 15,000 14,000 13,000
Less: Interest _ .
Taxable Income or EBT 15,000 14,000 13,000
Less: Tax at 40% 6,000 5,600 5,200
Net profit or EAT 9,000 8,400 7,800
Plus: Depreciation 10,000 10,000 10,000
NACFt or CFATt 19,000 18,400 17,800
3. Terminal cash flows in year 5 of TCF: CFAT5
Recovery of net working capital RM10,000
Salvage value 0
The TCF value of RM10,000 represents the recovery of working capital
initially invested that is no longer needed after the useful life of the machine.
In addition, the book values or salvage value of zero is based on the
assumption that the assets not sold after its useful life.
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In the event that the assets are sold after its useful life, for example at
RM20,000, the computation for the terminal cash flows will differ as follows:
Selling Price (SP) 20,000
Less: Book Value (BV) 0
Other costs 0.
Profits from sale or recaptured dep. 20,000
Note that there are no capital gains as selling price is less than the cost of
assets.
Tax liability from sale = 20,000(0.40) 8,000
Net proceeds from sale = 20,000 – 8,000 12,000
Therefore, terminal cash flows for the disposed asset:
Recovery of net working capital 10,000
Plus: Net proceeds from sale 12,000
Terminal cash flows 22,000
The above calculation can be simplified in the following equation.
TCFn = Recovery of net working capital + SP – (SP – BV)(T)
= 10,000 + 20,000 – (20,000 – 0)(0.4)
= 22,000
Note that he above equation is not applicable if the selling price is above the
cost of assets as capital gains require different tax treatments.
4. Time Line and Decision. To have a better view of its flows, a time line can
be developed as follows before the evaluation process:
Year 0 1 2 3 4 5 CFATt TCF
–60,000 19,000 19,000 19,000 18,400 17,800 10,000
It is advisable to develop the time line as it provides better view of the cash
flows involved in the particular project and ease of determining its present
value for capital budgeting decisions.
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Example for Replacement Decisions
Determining CFATs for replacement project is more complicated than the
expansion project as it involves incremental cost-benefit analysis. Other
procedures will remain the same.
For example, Iza Company is considering replacing an existing machine that
was purchased 2 years ago for RM50,000 with a computerized system that
could improve the company's operations. The old machine is being
depreciated under straight-line method over its useful life of 5 years with no
salvage value. Its current market value is RM40,000.
The new machine has a purchase price of RM60,000 and an estimated
salvage value of RM6,000 at the end of its useful life of 3 years. If the new
machine is purchased, the cash inflows are expected to increase by 10%
from the current level of RM30,000 per year. In addition, the cash outflows of
RM15,000 associated with the old machine are expected to decrease to
RM8,000 per year. Assume that the firm's cost of capital is 10%, marginal tax
rate is 40%, and capital gains rate is 28%.
1. Net Initial Investment at year or NICF: CFAT0
Purchase price of new machine 60,000
Less: Net proceeds from sale of old machine 40,000
Plus: Tax liability from sale of old machines 4,000a
NICF or CFAT0 24,000
a Computation of tax liability from the sale of old machine:
Book value = COA – Accumulated depreciation
= 50,000 – (50,000 / 5) 2
= RM30,000
Profit/Loss = SP – BV – Other costs
= 40,000 – 30,000 – 0
= RM10,000
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Since the company realized a profit of RM10,000 from the sale, it creates tax
liability:
Tax Liability = Profit/Loss (T)
= 10,000 (0.40)
= RM4,000
2. Operating cash flows in years 1-3 or NACF1-3: CFAT1-3
∆CFBT1-3 = Increase in cash inflows t + Decrease in cash outflows t
= (30,000)(0.10) + (15,000 – 8,000)
= RM10,000
∆Dep1-3 = (New Dep. t – Old Dep. t)
= ((60,000 – 6,000) / 3) – (50,000 / 5)
= RM18,000 – RM10,000
= RM8,000
∆CFAT1-3 = ∆CFBT t (1 – T) + ∆Dep. t (T)
= 10,000 (1 – 0.40) + 8,000 (0.40)
= RM9,200
3. Terminal cash flows in year 3; or TCF: CFAT3
Salvage value of the new machine RM6,000
4. Time Line and Decision. A proper time line can be developed to
show the cash flows associated with the above project after which it
can be evaluated for its attractiveness:
Year 0 1 2 3
CFATt
TCF
–24,000 9,200 9,200 9,200
6,000
In the incremental cash flow analysis, the focus is on the cash flows that
would change due to the acceptance of the proposed capital investment. Any
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existing cash flow that is irrelevant and does not change due to the proposed
project should be ignored in capital budgeting process. The net present value
method is the most common approach to evaluate the acceptability of the
proposed projects. This is due the fact that NPV is best method of evaluation
under normal circumstances.
11.2 CAPITAL BUDGETING TECHNIQUES The last part of capital budgeting is to develop proper evaluations and decisions making to
ensure the capital investment employed will contribute to the firm's value. Proper and
appropriate techniques must be employed in determining the worth of the projects before
accept-reject decisions is applied.
To illustrate the techniques involved, consider the alternative projects that Kurnia
Corporation is planning to evaluate for investment in 1995, as presented in Table 11-2. It
shows that both projects have the same initial investment or initial outlay of RM6,000 with
depreciation expenses of RM1,500 (=6,000 / 4) based on straight-line method with no
salvage value.
Table 11-2 Cash Flows of Investment Alternatives for Kurnia
Year Project A EAT CFAT Project B EAT CFAT1 2 3 4
RM900900900900
RM2,4002,4002,4002,400
RM500 700 900
1,200
RM2,0002,2002,4002,700
Total cash inflows RM3,600 RM9,600 RM3,300 RM9,300Average inflows RM 900 RM2,400 RM 825 RM2,325Salvage value RM - RM - Initial outlay RM6,000 RM6,000 Where EAT : Earnings after tax or net income
CFAT : Cash flows after tax = EAT + Depreciation
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11.2.1 Non-Discounted Cash Flow Method
Non discounted cash flow methods do not consider the time value of money
in the their analysis of capital investment. Two methods are average rate of
return and payback period.
Average Rate of Return (ARR)
The average rate of return or accounting rate of return measures
the profitability of a proposed capital investment as the ratio of
average earnings after taxes (EAT) to average investment. For Kurnia: