Capital Budgeting – Further
Considerations
For 9.220, Term 1, 2002/03
02_Lecture10.ppt
Lecture Outline
 Introduction
 The input for evaluating projects –
relevant cash flows
 Inflation: real vs. nominal analysis
 Taxes: the basics – preview this
section prior to the next lecture
 This section includes assigned readings;
make sure you do them prior to class.
 Summary and conclusions
Introduction
 Up to this point we have examined the methods or
techniques for capital budgeting: NPV, IRR, PI,
Payback, AAR.
 All, except AAR, use cash flows for the analysis. AAR
is not accepted as a good technique of analysis.
 Now we turn to cash-flow analysis. From where do we
get the cash flows? We need to determine which cash
flows should be included in the analysis and how to
include them properly. Here we bring in the concepts
of relevant cash flows, inflation, and taxes.
Relevant cash flows
 The main principles behind which
cash flows to include in capital
budgeting analysis are as follows:
1. Only include cash flows that change as a
result of the project being analyzed.
Include all cash flows that are impacted
by the project. This is often called an
incremental analysis – looking at how
cash flows change between not doing
the project vs. doing the project.
Relevant cash flows
2. Use projections of cash flows, not
accounting income.
 Accounting income ≠ cash. Accounting income
cannot be spent, a firm can be losing cash but
have positive accounting income, so accounting
income is not necessarily representative of cash.
Cash is what really generates value; cash can be
spent!
 Depending on arbitrary accounting policies,
income can easily be manipulated, so, by itself,
it is not a reliable input for capital budgeting
analysis.
Which cash flows are relevant to
the project analysis, which are not?
Examples
Type of Cash Flow
Sunk Costs
Opportunity Costs
Side Effects (or
incidental effects)
Interest Expense
(or financing
charges)
Is it Relevant to
the analysis? Why?
Working Capital Changes Required by
the Project – the cash flow effects
 Working capital (WC) items do not show up as costs
or revenues, however changes to the WC items either
require or free-up cash.
 Increases in current assets required for the project
imply that cash is used so a cash outflow occurs.
 To increase inventories requires cash.
 To increase the cash-register float also requires cash.
 An increase in accounts receivable (AR) means that
the cash you may have recognized, through revenue,
hasn’t been received yet. In effect, if your project
requires you to increase credit for your customers (an
AR increase), then this uses up cash that you would
otherwise have.
More on working capital changes
 Increases in current liabilities, on the other hand,
free-up cash, so a cash inflow occurs.
 Increasing accounts payable (AP) means that a cost
cash flow you may have recognized elsewhere has
not yet been paid, therefore the increase in AP is a
cash saving or inflow.
 For other payables, the analysis is the same.
 Salaries payable, utilities payable, etc.
 Overall, changes in net working capital (NWC)
represent cash flows.
Working Capital Example
 Without the Project
WC
item
2003
2004
2005
2006
 With the Project
(that ends in 2005)
WC
item
2003
2004
2005
2006
Inven
-tory
$10
$10
$10
$10
Inven
-tory
$12
$12
$14
$10
AR
$20
$21
$26
$25
AR
$26
$26
$28
$25
AP
$5
$5
$10
$10
AP
$8
$8
$13
$10
$25
$26
$26
$25
NWC
$30
$30
$29
$25
NWC
NWC Solution
 No project, NWC cash flows are as follows:
Cash flow
2003
2004
2005
2006
-$25
-$1
$0
$1
 With the project, NWC cash flows are as follows:
Cash flow
2003
2004
2005
2006
-$30
$0
$1
$4
 Change in NWC results in the following incremental cash
flows that should be included in the project analysis:
2003
2004
2005
2006
ΔCash flow
Salvage Values and Clean-up Costs
– Self Study
 The change in salvage value or
clean-up costs represent cash flows
related to a project.
 Example: consider a project to build
an ice-cream stand on some leased
land that is currently used for a
parking lot. At the end of the lease, in
5 years, the land must be returned to
a natural state.
Salvage/Clean-up Analysis – Self Study
 Without the Ice-Cream
Stand Project
 Year 0 cash flow: $0.
Nothing needs to be
done, the parking lot
can continue for 5
years.
 Year 5 cash flows:
-$20,000 to clean up
the parking lot
material. Sell the
parking lot gate for
scrap for $200.
 With the Ice-Cream
Stand Project
 Year 0 cash flows:
-$14,000 to partially
clean up the parking
lot material now. Sell
parking lot gate for
$1,500.
 Year 5 cash flows:
-$16,000 to clean up
the remaining parking
lot material and
remove ice cream
stand. Sell ice cream
Do the incremental stand for scrap for
analysis
$1,000.
Salvage/Clean-up Solution – Self Study
No Project
New Project
$0
Yr.0
Yr. 5
-$20,000
+$200
Net=-$19,800
-$14,000
+$1,500
Net=-$12,500
-$16,000
+$1,000
Net=-$15,000
Change
(incremental
cash flow)
-$12,500
+$4,800
Inflation
 Sometimes a projected cash flow is
given as a nominal amount (the
expected actual amount of cash to
be received or paid).
 Sometimes a projected cash flow is
given as a real amount (the current
or date 0 purchasing power of the
cash flow.
 Note, the real cash flow is not the PV.
Nominal/Real Cash Flow Examples
 Fred’s contract with his employer states that he will be
paid $100,000 three years from now.
 Currently, the “basket of goods” used to measure the
consumers’ price index costs $125. Sue expects to
receive a cash flow in four years that will allow her to
purchase 100 of these baskets.

This can be represented by a real cash flow.
Are real cash flows the same as
present values?
 No!
 Which would you prefer to receive, $1,250
today (which can buy 10 “baskets of
goods”) or a dollar amount in 5 year that
will buy 10 “baskets of goods” then?
 The $1,250 today is preferred even though, in
terms of purchasing power, both payments give
the same purchasing power.
 Since the $1,250 today is preferred, the two
cash flows cannot have the same present value.
How do we discount real cash
flows?
 Consider the basket of goods that costs
$125 today. Suppose inflation is expected
to be 5% each year for the next 5 years.
 How much, in real dollars, do we need to be able
to purchase 10 baskets in 5 years?
 Let this be our real cash flow
 How much, in nominal dollars do we need to be
able to purchase the same 10 baskets in 5
years?
 This must be the equivalent nominal cash flow
 What is the relation between the real and
nominal cash flow? (be exact – formula?)
Discounting real vs. nominal cash
flows (continued)
 If the relevant discount rate for the
nominal cash flow is 12%, then what
is its PV today?
 What discount rate applied to the real
cash flow would get the same PV
today?
 What is the relation between the real
discount rate and the nominal
discount rate? (be exact – formula?)
Conclusions on real and nominal
cash flows
 It is possible to express any cash flow as
either a real amount or a nominal
amount.
 Since the real and nominal amounts are
equivalent, the PV’s must be equivalent,
so remember the rule:
Use of real cash flows
 If a project’s cash flows are expected
to grow with inflation, then it may be
more convenient to express the cash
flows as real amounts rather than
trying to predict inflation and the
nominal cash flows.
Taxes: the basics
 Unfortunately, in most civilized
countries both corporations and
individuals must pay tax on income
and profits.
 Tax is a cash outflow (yes, really). So
we must include taxes in our capital
budgeting analysis.
Calculating tax effects from non-financing
components of the income statement.
 Recall the income
statement you learned
about in accounting …
 Whatever affects the
income statement
amounts will also affect
the taxes paid.


*Assume depreciation here
is what is recognized for tax
purposes. In Canada, this is
called capital cost
allowance, CCA.
**The interest expense is
financing related, so
interest and its tax effect
should be removed from
our analysis.
Revenues
Cost of goods sold
Gross Margin
Selling, general, and
admin expenses
R&D expense
Depreciation Expense*
Interest Expense**
Earnings Before Tax
$1,000
$600
$400
$125
$50
$100
$25
$100
Tax (at 40%)
$40
Earnings after Tax
(Net Income)
$60
Tax consequences and after tax cash
flows (assume a tax rate, Tc, of 40%)
Item
Before-tax
amount
Before-tax
cash flow
After-tax
cash flow
Revenue
Rev
$10
Rev
$10
=Rev(1-Tc)
=$10(1-.4)
=$6
Expense
Exp
$10
-Exp
-$10
=-Exp(1-Tc)
=-$10(1-.4)
=-$6
CCA
CCA
$10
$0
=+CCATc
=+$10 0.4
=+$4
Yearly cash flows after tax
 Normally we project yearly cash flows for a
project and convert them into after-tax
amounts.
 CCA deductions are due to an asset
purchase for a project. CCA is calculated as
a % of the Undepreciated Capital Cost
(UCC). Since a % amount is deducted each
year, the UCC will never reach zero so CCA
deductions can actually continue even after
the project has ended (and thus shelter
future income from taxes). All CCA-caused
tax savings should be recognized as cash
inflows for the project that caused them.
CCA Preview – read thoroughly for
next class
 Read the assigned sections of Chapter 7, then pay
particular attention to the following:
 See table 7.3 and accompanying text in the chapter
for an example of CCA and UCC calculations. See
table 7.7 and accompanying text in the chapter for
the corresponding CCA tax shields and the PV of the
tax savings due to CCA.
 Equation 7.6, p. 203, allows us to calculate the sum
of the present values of all CCA tax shields and
includes an adjustment in case the asset is sold (and
reduces future CCA deductions). This equation,
although complicated looking, is nothing more than
the PV of one declining perpetuity minus the PV of a
second declining perpetuity.
Summary and Conclusions
 All relevant cash flows for a project must be included
in the capital budgeting analysis for a project.
 Relevant cash flows are those that change as a result
of accepting the project.
 We exclude things that don’t change. We also exclude
interest charges or financing expenses because these
are accounted for in the discount rate.
 Tax effects must also be included. CCA is a special
case to consider because the tax savings may
continue beyond the end of the project.
 Once we have all after-tax cash flow effects projected,
we can conduct our analysis of a project using our
preferred methods: NPV, IRR, or PI; Payback may also
be used but its oversimplification should be
recognized.