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FINANCIAL MANAGEGEMENT

CHAPTER 12
CAPITAL BUDGETIG AND ESTIMATING CASH FLOWS

BY
LUH KOMANG YURIKA ERNAWATI (1406305014)
NI NYOMAN TRI SETYA PRAJAYANTI (1506305080)
PUTU NADIANI PUTRI UTAMA (1506305130)

FACULTY OF ECONOMIC AND BUSINESS


UDAYANA UNIVERSITY

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ACKNOWLEDGEMENT
Praise to God who has helped his servant finish this paper with great ease. Without
His help we may not be able to complete the authors well.

The paper is organized so that readers can find out about Capital Budgeting and
Estimating Cash Flows. This paper set up by the compiler with various obstacles. Whether it
came from self constituent or who come from outside. But with patience and especially the
help of God finally this paper can be resolved.

Authors also thank the lecturers who have helped to finish this paper.
Hopefully this paper can provide a broader insight to the reader. Although this paper have
advantages and disadvantages. Authors beg for advice and criticism. Thank you.

Writers

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TABLE OF CONTENT
ACKNOLEDGEMENT.......................................................................................................2
TABLE OF CONTENT.......................................................................................................3
CHAPTER I INTRODUCTION........................................................................................4
1.1 Background......................................................................................................................4
1.2 Formulation of Problem...................................................................................................4
1.3 Objective..........................................................................................................................5
CHAPTER II CONTENT...................................................................................................6
2.1 The Capital Budgeting Process : An Overview...............................................................6
2.2 Generating Investment Project Proposals........................................................................6
2.3 Estimating Project After-Tax Incremental Operating Cash Flows...............................7
CHAPTER III CONCLUTION..........................................................................................17

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CHAPTER I
PREFACE
1.1 Background
Having just explored ways to efficiently manage working capital (current assets and
their supporting financing), we now turn our attention to decisions that involve long-lived
assets. These decisions involve both investment and financing choices, the first of which
takes up the next three chapters.
When a business makes a capital investment, it incurs a current cash outlay in the
expectation of future benefits. Usually, these benefits extend beyond one year in the future.
Examples include investment in assets, such as equipment, buildings, and land, as well as the
introduction of a new product, a new distribution system, or a new program for research and
development. In short, the firms future success and profitability depend on long-term
decisions currently made.
An investment proposal should be judged in relation to whether or not it provides a
return equal to, or greater than, that required by investors.1 To simplify our investigation of
the methods of capital budgeting in this and the following chapter, we assume that the
required return is given and is the same for all investment projects. This assumption implies
that the selection of any investment project does not alter the operating, or business-risk,
complexion of the firm as perceived by financing suppliers. In Chapter 15 we investigate how
to determine the required rate of return, and in Chapter 14 we allow for the fact that different
investment projects have different degrees of business risk. As a result, the selection of an
investment project may affect the business-risk complexion of the firm, which, in turn, may
affect the rate of return required by investors. For purposes of introducing capital budgeting
in this and the next chapter, however, we hold risk constant.

1.2 Formulation of Problem


The formulation of problem in this paper are:
a. What is capital budgeting and what steps involved in the capital budgeting process?
b. How tax considerations, as well as depreciation for tax purposes, affect capital budgeting
cash flows?
c. How initial, interim, and terminal period after-tax, incremental, operating cash flows
associated with a capital investment project?

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1.3 Objective
The purpose of writing this paper are:
a. To define capital budgeting and identify the steps involved in the capital budgeting
process.
b. To understand how tax considerations, as well as depreciation for tax purposes, affect
capital budgeting cash flows.
c. To determine initial, interim, and terminal period after-tax, incremental, operating cash
flows associated with a capital investment project.

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CHAPTER II
CONTENT

2.1. THE CAPITAL BUDGETING PROCESS : AN OVERVIEW


Capital Budgeting is the process of identifying, analyzing, and selecting investment
projects whose returns (cash flows) are expected to extend beyond one year.
The capital budgeting involves:
Generate investment proposals consistent with the firms strategic objectives.
Estimate after-tax incremental operating cash flows for the investment projects.
Evaluate project incremental cash flows.
Select projects based on a value-maximizing acceptance criterion.
Reevaluate implemented investment projects continually and perform post audits
for completed projects.

2.2 GENERATE INVESTMENT PROJECT PROPOSALS


Investment project proposals can stem from a variety of sources. For purposes of
analysis, projects may be classified into one of five categories:
1. New products or expansion of existing products
2. Replacement of equipment or buildings
3. Research and development
4. Exploration
5. Other (for example, safety-related or pollution-control devices)
For a new product, the proposal usually originates in the marketing department.
A proposal to replace a piece of equipment with a more sophisticated model, however,
usually arises from the production area of the firm. In each case, efficient
administrative procedures are needed for channeling investment requests. All
investment requests should be consistent with corporate strategy to avoid needless
analysis of projects incompatible with this strategy. (McDonalds probably would not
want to sell cigarettes in its restaurants, for example.)
Most firms screen proposals at multiple levels of authority. For a proposal
originating in the production area, the hierarchy of authority might run (1) from
section chiefs, (2) to plant managers, (3) to the vice president for operations, (4) to a
capital expenditures committee under the financial manager, (5) to the president, and

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(6) to the board of directors. How high a proposal must go before it is finally
approved usually depends on its cost. The greater the capital outlay, the greater the
number of screens usually required. Plant managers may be able to approve
moderate-sized projects on their own, but only higher levels of authority approve
larger ones. Because the administrative procedures for screening investment proposals
vary from firm to firm, it is not possible to generalize. The best procedure will depend
on the circumstances. It is clear, however, that companies are becoming increasingly
sophisticated in their approach to capital budgeting.

2.3 ESTIMATING PROJECT AFTER-TAX INCREMENTAL OPERATING CASH


FLOWS
One of the most important tasks in capital budgeting is estimating future cash
flows for a project. The final results we obtain from our analysis are no better than the
accuracy of our cash-flow estimates. Because cash, not accounting income, is central
to all decisions of the firm, we express whatever benefits we expect from a project in
terms of cash flows rather than income flows. The firm invests cash now in the hope of
receiving even greater cash returns in the future. Only cash can be reinvested in the
firm or paid to shareholders in the form of dividends. In capital budgeting, good guys
may get credit, but effective managers get cash. In setting up the cash flows for
analysis, a computer spreadsheet program is invaluable. It allows one to change
assumptions and quickly produce a new cash-flow stream.
Cash flows should be determined on an after-tax basis. The initial investment
outlay, as well as the appropriate discount rate, will be expressed in after-tax terms.
Therefore all forecasted flows need to be stated on an equivalent, after-tax basis.
In addition, the information must be presented on an incremental basis, so that
we analyze only the difference between the cash flows of the firm with and without the
project. For example, if a firm contemplates a new product that is likely to compete
with existing products, it is not appropriate to express cash flows in terms of estimated
total sales of the new product. We must take into account the probable
cannibalization of existing products and make our cash-flow estimates on the basis
of incremental sales. When continuation of the status quo results in loss of market
share, we must take this into account when analyzing what happens if we do not make
a new investment. That is, if cash flows will erode if we do not invest, we must factor
this into our analysis. The key is to analyze the situation with and without the new

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investment and where all relevant costs and benefits are brought into play. Only
incremental cash flows matter.
In this regard, sunk costs must be ignored. Our concern lies with incremental
costs and benefits. Unrecoverable past costs are irrelevant and should not enter into the
decision process. Also, we must be mindful that certain relevant costs do not
necessarily involve an actual dollar outlay. If we have allocated plant space to a project
and this space can be used for something else, its opportunity cost must be included
in the projects evaluation. If a currently unused building needed for a project can be
sold for $300,000, that amount (net of any taxes) should be treated as if it were a cash
outlay at the outset of the project. Thus, in deriving cash flows, we need to consider
any appropriate opportunity costs.
When a capital investment contains a current asset component, this component
(net of any spontaneous changes in current liabilities) is treated as part of the capital
investment and not as a separate working capital decision. For example, with the
acceptance of a new project it is sometimes necessary to carry additional cash,
receivables, or inventories. This investment in working capital should be treated as a
cash outflow at the time it occurs. At the end of a projects life, the working capital
investment is presumably returned in the form of an additional cash inflow.
In estimating cash flows, anticipated inflation must be taken into account. Often
there is a tendency to assume erroneously that price levels will remain unchanged
throughout the life of a project. If the required rate of return for a project to be
accepted embodies a premium for inflation (as it usually does), then estimated cash
flows must also reflect inflation. Such cash flows are affected in several ways. If cash
inflows ultimately arise from the sale of a product, expected future prices affect these
inflows. As for cash outflows, inflation affects both expected future wages and material
costs.

Tax Considerations and Depreciation


Depreciation represents the systematic allocation of the cost of a capital asset over a
period of time for financial reporting purposes, tax purposes, or both.
Everything else equal, the greater the depreciation charges, the lower the taxes paid by
the firm.
Depreciation is a noncash expense.

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Depreciation and the MACRS Method
Generally, profitable firms prefer to use an accelerated method for tax reporting
purposes (MACRS).
Assets are depreciated (MACRS) on one of eight different property classes.
Generally, the half-year convention is used for MACRS.

MACRS Sample Schedule

Depreciable Basis
In tax accounting, the fully installed cost of an asset. This is the amount that, by law,
may be written off over time for tax purposes.

Depreciable Basis = Cost of Asset + Capitalized Expenditures

In general, if a depreciable asset used in business is sold for more than its
depreciated (tax) book value, any amount realized in excess of book value but less than
the assets depreciable basis is considered a recapture of depreciation and is taxed at
the firms ordinary income tax rate. This effectively reverses any positive tax benefits
of having taken too much depreciation in earlier years that is, reducing (tax) book
value below market value. If the asset happens to sell for more than its depreciable
basis (which, by the way, is not too likely), the portion of the total amount in excess of
the depreciable basis is taxed at the capital gains tax rate (which currently is equal to
the firms ordinary income tax rate, or a maximum of 35 percent).

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If the asset sells for less than (tax) book value, a loss is incurred equal to the
difference between sales price and (tax) book value. In general, this loss is deducted
from the firms ordinary income. In effect, an amount of taxable income equal to the
loss is shielded from being taxed. The net result is a tax-shield savings equal to the
firms ordinary tax rate multiplied by the loss on the sale of the depreciable asset. Thus
a paper loss is cause for a cash savings.

Calculating the Incremental Cash Flows


We now face the task of identifying the specific components that determine a projects
relevant cash flows. We need to keep in mind both the concerns enumerated in our cash-flow
checklist as well as the various tax considerations just discussed. It is helpful to place project
cash flows into three categories based on timing :
1. Initial cash outflow: the initial net cash investment.
2. Interim incremental net cash flows: those net cash flows occurring after the initial cash
investment but not including the final periods cash flow.

3. Terminal-year incremental net cash flow: the final periods net cash flow.

(This periods cash flow is singled out for special attention because a particular set of cash
flows often occurs at project termination.)

Initial Cash Outflow. In general, the initial cash outflow for a project is determined as
follows in Table 12.3. As seen, the cost of the asset is subject to adjustments to reflect the
totality of cash flows associated with its acquisition. These cash flows include installation
costs, changes in net working capital, sale proceeds from the disposition of any assets
replaced, and tax adjustments.

(a) Cost of new asset(s)


(b) + Capitalized expenditures (for example, installation costs, shipping expenses, etc.)*
(c) +(-) Increased (decreased) level of net working capital**
(d) - Net proceeds from sale of old asset(s) if the investment is a replacement decision
(e) +(-) Taxes (tax savings) due to the sale of old asset(s) if the investment is a
replacement decision
(f ) = Initial cash outflow

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*Asset cost plus capitalized expenditures form the basis on which tax depreciation is
computed.
**Any change in working capital should be considered net of any spontaneous changes in
currentliabilities that occur because the project is impleme

Interim Incremental Net Cash Flows.


After making the initial cash outflow that is necessary to begin implementing a project, the
firm hopes to benefit from the future cash inflows generated by the project. Generally, these
future cash flows can be determined by following the step-by-step procedure outlined in
Table 12.4.
Notice that we first deduct any increase (add any decrease) in incremental tax depreciation
related to project acceptance see step (b) in determining the net change in income before
taxes. However, a few steps later we add back any increase (deduct any decrease) in tax
depreciation see step (f) in determining incremental net cash flow for the period.
What is going on here? Well, tax depreciation itself, as you may remember, is a noncash
charge against operating income that lowers taxable income. So we need to consider it as
we determine the incremental effect that project acceptance has on the firms taxes. However,
we ultimately need to add back any increase (subtract any decrease) in tax depreciation to
our resulting net change in income after taxes figure so as not to understate the projects
effect on cash flow.

(a) Net increase (decrease) in operating revenue less (plus) any net increase (decrease) in
operating expenses, excluding depreciation
(b) -(+) Net increase (decrease) in tax depreciation charges
(c) = Net change in income before taxes
(d) -(+) Net increase (decrease) in taxes
(e) = Net change in income after taxes
(f ) +() Net increase (decrease) in tax depreciation charges
(g) = Incremental net cash flow for the period

Terminal-Year Incremental Net Cash Flow. Finally, we turn our attention to determining
the projects incremental cash flow in its final, or terminal, year of existence. We apply the
same step-by-step procedure for this periods cash flow as we did to those in all the interim
periods. In addition, we give special recognition to a few cash flows that are often connected

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only with project termination. These potential project windup cash flows are (1) the salvage
value (disposal/reclamation costs) of any sold or disposed assets, (2) taxes (tax savings)
related to asset sale or disposal, and (3) any project-termination-related change in working
capital generally, any initial working capital investment is now returned as an additional
cash inflow. Below summarizes all the necessary steps and highlights those steps that are
reserved especially for project termination.
(a) Net increase (decrease) in operating revenue less (plus) any net increase (decrease) in
operating expenses, excluding depreciation
(b) -(+) Net increase (decrease) in tax depreciation charges
(c) = Net change in income before taxes
(d) -(+) Net increase (decrease) in taxes
(e) = Net change in income after taxes
(f ) +(-) Net increase (decrease) in tax depreciation charges
(g) = Incremental cash flow for the terminal year before project windup considerations
(h) +(-) Final salvage value (disposal/reclamation costs) of new asset(s)
(i) -(+) Taxes (tax savings) due to sale or disposal of new asset(s)
(j) +(-) Decreased (increased) level of net working capital*
(k) = Terminal year incremental net cash flow

*Any change in working capital should be considered net of any spontaneous changes in
current
liabilities that occur because the project is terminated.

Example of Asset Expansion


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 years. BW is in the 40% tax bracket.

Initial Cash Outflow

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a) $50,000

b) + 20,000

c) + 5,000

d) 0 (not a replacement)

e) + () 0 (not a replacement)

f) = $75,000*

Incremental Cash Flows

Year 1 Year 2 Year 3 Year 4

a) $40,000 $40,000 $40,000 $40,000

b) 23,331 31,115 10,367 5,187

c) = $16,669 $ 8,885 $29,633 $34,813

d) 6,668 3,554 11,853 13,925

e) = $10,001 $ 5,331 $17,780 $20,888

f) + 23,331 31,115 10,367 5,187

g) = $33,332 $36,446 $28,147 $26,075

a) $26,075 The incremental cash flow from the previous slide in Year 4.

b) + 10,000 Salvage Value.

c) 4,000.40*($10,000 - 0) Note, the asset is fully depreciated at the end of Year 4.

d) + 5,000 NWC - Project ends.

e) = $37,075 Terminal-year incremental cash flow.

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Asset Expansion

Year 0 Year 1 Year 2 Year 3 Year 4

$75,000* $33,332 $36,446 $28,147 $37,075

* Notice again that this value is a negative cash flow as we calculated it as the initial cash
OUTFLOW in slide 12-23.

Example of an Asset Replacement Project

Let us assume that previous asset expansion project is actually an asset replacement project.
The original basis of the machine was $30,000 and depreciated using straight-line over five
years ($6,000 per year). The machine has two years of depreciation and four years of useful
life remain-ing. BW can sell the current machine for $6,000. The new machine will not
increase revenues (remain at $110,000) but it decreases operating expenses by $10,000 per
year (old = $80,000). NWC will rise to $10,000 from $5,000 (old).

Initial Cash Outflow

a) $50,000

b) + 20,000

c) + 5,000

d) 6,000 (sale of old asset)

e) 2,400 <---- (tax savings from loss on sale of old asset)

f) = $66,600

Calculation of the Change in Depreciation

Year 1 Year 2 Year 3 Year 4

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a) $23,331 $31,115 $10,367 $ 5,187

b) 6,000 6,000 0 0

c) = $17,331 $25,115 $10,367 $ 5,187

a) Represent the depreciation on the new project.

b) Represent the remaining depreciation on the old project.

c) Net change in tax depreciation charges

Incremental Cash Flows

Year 1 Year 2 Year 3 Year 4

a) $10,000 $10,000 $10,000 $10,000

b) 17,331 25,115 10,367 5,187

c) = $ 7,331 $15,115 $ 367 $ 4,813

d) 2,932 6,046 147 1,925

e) = $ 4,399 $ 9,069 $ 220 $ 2,888

f) + 17,331 25,115 10,367 5,187

g) = $12,932 $16,046 $10,147 $ 8,075

Terminal-Year Incremental Cash Flows

a) $ 8,075 The incremental cash flow in Year 4

b) + 10,000 Salvage Value.

c) 4,000 (.40)*($10,000 0). Note, the asset is fully depreciated at


the end of Year 4.

d) + 5,000 Return of added NWC.

e) = $19,075 Terminal-year incremental cash flow.

Summary of Project Net Cash Flows

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Asset Expansion

Year 0 Year 1 Year 2 Year 3 Year 4

$75,000 $33,332 $36,446 $28,147 $37,075

Asset Replacement

Year 0 Year 1 Year 2 Year 3 Year 4

$66,600 $12,933 $16,046 $10,147 $19,075

CHAPTER III

CONCLUTION

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Capital Budgeting is the process of identifying, analyzing, and selecting investment
projects whose returns (cash flows) are expected to extend beyond one year. There are 3
Steps in Capital Budgeting Process :Generate investment proposals consistent with the firms
strategic objectives, estimate after-tax incremental operating cash flows for the investment
projects, evaluate project incremental cash flows.

Depreciation represents the systematic allocation of the cost of a capital asset over a
period of time for financial reporting purposes, tax purposes, or both.Everything else equal,
the greater the depreciation charges, the lower the taxes paid by the firm.Depreciation is a
noncash expense.

There are 3 Steps involved in determining the net cash flow. They are : Cash outflow (
used to determine how much cash we have to bear in order to obtain the asset), Interim Cash
incremental Flow ( used to measure how much money we have to obtain to cover the cash
outflow), and the last is the terminal cash flow.

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