Chapter 8
Capital
Budgeting
Cash Flows
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Learning Goals
1. Understand the motives for key capital
budgeting expenditures and the steps in the
capital budgeting process.
2. Define basic capital budgeting terminology.
3. Discuss relevant cash flows, expansion versus
replacement decisions, sunk costs and
opportunity costs, and international capital
budgeting.
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Learning Goals (cont.)
4. Calculate the initial investment associated with
a proposed capital expenditure.
5. Find the relevant operating cash inflows
associated with a proposed capital expenditure.
6. Determine the terminal cash flow associated
with a proposed capital expenditure.
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8-3
The Capital Budgeting Decision Process
• Capital Budgeting is the process of identifying,
evaluating, and implementing a firm’s investment
opportunities.
• It seeks to identify investments that will enhance a
firm’s competitive advantage and increase
shareholder wealth.
• The typical capital budgeting decision involves a
large up-front investment followed by a series of
smaller cash inflows.
• Poor capital budgeting decisions can ultimately result
in company bankruptcy.
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Table 8.1 Key Motives for Making
Capital Expenditures
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Steps in the Process
1. Proposal Generation
2. Review and Analysis
Our Focus is
on Step 2 and 3
3. Decision Making
4. Implementation
5. Follow-up
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Basic Terminology: Independent versus
Mutually Exclusive Projects
• Independent Projects, on the other hand, do not
compete with the firm’s resources. A company can
select one, or the other, or both—so long as they meet
minimum profitability thresholds.
• Mutually Exclusive Projects are investments that
compete in some way for a company’s resources—a
firm can select one or another but not both.
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8-7
Basic Terminology: Unlimited Funds
versus Capital Rationing
• If the firm has unlimited funds for making
investments, then all independent projects that
provide returns greater than some specified level
can be accepted and implemented.
• However, in most cases firms face capital
rationing restrictions since they only have a
given amount of funds to invest in potential
investment projects at any given time.
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8-8
Basic Terminology: Accept-Reject versus
Ranking Approaches
• The accept-reject approach involves the
evaluation of capital expenditure proposals to
determine whether they meet the firm’s
minimum acceptance criteria.
• The ranking approach involves the ranking of
capital expenditures on the basis of some
predetermined measure, such as the rate of
return.
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Basic Terminology: Conventional versus
Nonconventional Cash Flows
Figure 8.1 Conventional Cash Flow
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Basic Terminology: Conventional versus
Nonconventional Cash Flows (cont.)
Figure 8.2 Nonconventional
Cash Flow
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8-11
The Relevant Cash Flows
• Incremental cash flows:
– are cash flows specifically associated with the
investment, and
– their effect on the firms other investments (both
positive and negative) must also be considered.
For example, if a day-care center decides to open another
facility, the impact of customers who decide to move from
one facility to the new facility must be considered.
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Relevant Cash Flows:
Major Cash Flow Components
Figure 8.3 Cash Flow Components
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Relevant Cash Flows: Expansion Versus
Replacement Decisions
• Estimating incremental cash flows is relatively
straightforward in the case of expansion
projects, but not so in the case of replacement
projects.
• With replacement projects, incremental cash
flows must be computed by subtracting existing
project cash flows from those expected from the
new project.
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Figure 8.4 Relevant Cash Flows for
Replacement Decisions
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Relevant Cash Flows: Sunk Costs
Versus Opportunity Costs
• Note that cash outlays already made (sunk
costs) are irrelevant to the decision process.
• However, opportunity costs, which are cash
flows that could be realized from the best
alternative use of the asset, are relevant.
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Finding the Initial Investment
Table 8.2 The Basic Format for Determining
Initial Investment
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Finding the Initial Investment (cont.)
Table 8.3 Tax Treatment on Sales of
Assets
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8-18
Finding the Initial Investment (cont.)
Hudson Industries, a small electronics company, 2
years ago acquired a machine tool with an installed
cost of $100,000. The asset was being depreciated
under MACRS using a 5-year recovery period. Thus
52% of the cost (20% + 32%) would represent
accumulated depreciation at the end of year two.
Book Value = $100,000 - $52,000 = $48,000
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8-19
Finding the Initial Investment
• Sale of the Asset for More Than Its Purchase Price
If Hudson sells the old asset for $110,000, it realizes a
gain of $62,000 ($110,000 - $48,000). Technically, the
difference between the cost and book value ($52,000) is
called recaptured depreciation and the difference
between the sales price and purchase price ($10,000) is
called a capital gain. Under current corporate tax laws,
the firm must pay taxes on both the gain and recaptured
depreciation at its marginal tax rate.
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8-20
Finding the Initial Investment (cont.)
• Sale of the Asset for More Than Its Book Value but
Less than Its Purchase Price
If Hudson sells the old asset for $70,000, it realizes
a gain in the form of recaptured depreciation of
$22,000 ($70,000–$48,000) which is taxed at the
firm’s marginal tax rate.
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Finding the Initial Investment (cont.)
• Sale of the Asset for Its Book Value
If Hudson sells the old asset for its book value of
$48,000, there is no gain or loss and therefore no tax
implications from the sale.
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Finding the Initial Investment (cont.)
• Sale of the Asset for Less Than Its Book Value
If Hudson sells the old asset for $30,000 which is less than
its book value of $48,000, it experiences a loss of $18,000
($48,000 - $30,000). If this is a depreciable asset used in
the business, the loss may be used to offset ordinary
operating income. If it is not depreciable or used in the
business, the loss can only e used to offset capital gains.
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Finding the Initial Investment (cont.)
Figure 8.5 Taxable Income from Sale of Asset
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Finding the Initial Investment (cont.)
• Change in Net Working Capital
Danson Company, a metal products manufacturer, is
contemplating expanding operations. Financial analysts
expect that the changes in current accounts summarized
in Table 8.4 on the following slide will occur and will be
maintained over the life of the expansion.
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Finding the Initial Investment (cont.)
Table 8.4 Calculation of Change in Net Working
Capital for Danson Company
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Finding the Initial Investment (cont.)
Powell Corporation, a large diversified manufacturer of aircraft
components, is trying to determine the initial investment required
to replace an old machine with a new, more sophisticated model.
The machine’s purchase price is $380,000 and an additional
$20,000 will be necessary to install it. It will be depreciated
under MACRS using a 5-year recovery period. The firm has
found a buyer willing to pay $280,000 for the present machine
and remove it at the buyers expense. The firm expects that a
$35,000 increase in current assets and an $18,000 increase in
current liabilities will accompany the replacement. Both ordinary
income and capital gains are taxed at 40%.
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Finding the Initial Investment (cont.)
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Finding the Operating Cash Inflows
Powell Corporation’s estimates of its revenues and expenses
(excluding depreciation and interest), with and without the new
machine described in the preceding example, are given in
Table 8.5. Note that both the expected usable life of the
proposed machine and the remaining usable life of the existing
machine are 5 years. The amount to be depreciated with the
proposed machine is calculated by summing the purchase
price of $380,000 and the installation costs of $20,000.
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Finding the Operating
Cash Inflows (cont.)
Table 8.5 Powell Corporation’s Revenue and
Expenses (Excluding Depreciation and Interest)
for Proposed and Present Machines
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Table 8.6 Depreciation Expense for
Proposed and Present Machines for Powell
Corporation
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Table 8.7 Calculation of Operating Cash
Inflows Using the Income Statement Format
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Table 8.8 Calculation of Operating Cash
Inflows for Powell Corporation’s Proposed
and Present Machines
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Table 8.9 Incremental (Relevant) Operating
Cash Inflows for Powell Corporation
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Finding the Terminal Cash Flow
Table 8.10 The Basic Format for Determining
Terminal Cash Flow
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Finding the Terminal Cash Flow (cont.)
Continuing with the Powell Corporation example, assume that
the firm expects to be able to liquidate the new machine at the
end of its 5-year useable life to net $50,000 after paying
removal and cleanup costs. The old machine can be
liquidated at the end of the 5 years to net $10,000. The firm
expects to recover its $17,000 net working capital investment
upon termination of the project. Again, the tax rate is 40%.
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Finding the Terminal Cash Flow (cont.)
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Summarizing the Relevant Cash Flows
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