Chapter 12 Rovy

CHAPTER 12
CAPITAL BUDGETING
AND ESTIMATING CASH
FLOW
What is Capital Budgeting?
The process of identifying, analyzing and
selecting investments projects whose
returns (cash flows) are expected to
extend beyond one year.
The Capital Budgeting
Process
Generate investments proposals
consistent with the firms strategic
objectives
Evaluate project incremental cash flows.
Selecting project based on a value
maximizing acceptance criterion.
Classification of Investment
Project Proposal
1. New products or expansion of existing
products
2. Replacement of existing equipment or
buildings
3. Research and development
4. Exploration
5. Other (e.g., safety or pollution related)
Screening Proposals
and Decision Making
1. Section Chiefs
2. Plant Managers
3. VP for Operations
4. Capital Expenditures Committee
5. President
6. Board of Directors
Estimating After-Tax
Incremental Cash Flows
Cash (not accounting income)
flows
Operating (not financing) flows
After-tax flows
Incremental flows
Estimating After-Tax
Ignore sunk costs
Include opportunity costs
Include project-driven changes in
working capital net of
spontaneous changes in current
liabilities
Include effects of inflation
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.
Depreciation and the MACRS
Method
(Modified Accelerated Cost Recovery
System)
Everything else equal, the greater the
depreciation charges, the lower the taxes
paid by the firm.
Depreciation is a noncash expense.
Assets are depreciated (MACRS) on one of
eight different property classes.
Generally, the half-year convention is
used for MACRS.
MACRS Sample Schedule
Recovery Property Class

Year 3-Year 5-Year 7-Year
1 33.33% 20.00% 14.29%
2 44.45 32.00 24.49
3 14.81 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46
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.
Cost of Asset + Capitalized Expenditures

=Depreciable Basis
Capitalized Expenditures
are expenditures that may provide benefits
into the future and therefore are treated as
capital outlays and not as expenses of the
period in which they were incurred.
Examples: Shipping and installation

Sale or Disposal of a
Depreciable Asset
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)
Corporate Capital Gains / Losses
Currently, capital gains are taxed at

ordinary income tax rates for
corporations, or a maximum 35%.
Capital losses are deductible only against
capital gains.
Calculating the Incremental CashFlows
Initial cash outflow -- the initial net cash

investment.
Interim incremental net cash flows --
those net cash flows occurring after the
initial cash investment but not including
the final periods cash flow.
Terminal-year incremental net cash flows
-- the final periods net cash flow.
Initial Cash Outflow
a) Cost of new assets

b) + Capitalized expenditures
c) + (-) Increased (decreased) NWC
d) - Net proceeds from sale of
old asset(s) if replacement
e) + (-) Taxes (savings) due to the sale
of old asset(s) if replacement
f) = Initial cash outflow
a) Net incr. (decr.) in operating revenue less

(plus) any net incr. (decr.) in operating
expenses, excluding depr.
b) - (+) Net incr. (decr.) in tax depreciation
c) = Net change in income before taxes
d) - (+) Net incr. (decr.) in taxes
e) = Net change in income after taxes
f) + (-) Net incr. (decr.) in tax depr.
charges
g) = Incremental net cash flow for period
Terminal-Year Incremental Cash Flows
a) Calculate the incremental net cash flow

for the terminal period
b) + (-) Salvage value (disposal/reclamation
costs) of any sold or disposed assets
c) - (+) Taxes (tax savings) due to asset sale
or disposal of new assets
d) + (-) Decreased (increased) level of net
working capital
e) = Terminal year incremental net cash flow
El Fin!
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Chapter 12 Rovy

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CHAPTER 12

Recovery Property Class

Cost of Asset + Capitalized Expenditures

Examples: Shipping and installation

Currently, capital gains are taxed at

Initial cash outflow -- the initial net cash

a) Cost of new assets

a) Net incr. (decr.) in operating revenue less

a) Calculate the incremental net cash flow

Gracias para Escuchando!

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