12 Capital Budgeting and Estimating Cash
Flows
Lecture Handout for Chapter 12
Chapter 12 is covered in lectures 18 and 19.
Capital Budgeting Process
Capital budgeting is the process of identifying, analyzing, and selecting
investment projects whose returns (cash flows) are expected to extend
beyond one year. Specifically, capital budgeting involves
1. Generating investment project proposals consistent with the firm’s
strategic objectives;
2. Estimating after tax incremental operating cash flows for the
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investment projects;
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3. Evaluating project incremental cash flows;
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4. Selecting projects based on a value-maximizing acceptance criterion;
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5. Continually reevaluating implemented investment projects and
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performing post audits for completed projects.
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Because cash, not accounting income, is central to all decisions of the firm,
we express the benefits we expect to receive from a project in terms of cash
flows rather than income flows.
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Estimating Project “After-Tax Incremental Operating Cash Flows”
Cash flows should be measured on an incremental, after-tax basis. In
addition, our concern is with operating, not financing, flows.
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Tax depreciation under the Modified Accelerated Cost Recovery System has a
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significant effect on the size and pattern of cash flows. Also affecting the size
and pattern of cash flows is the presence of salvage value
(disposal/reclamation costs) and project-driven changes in working capital
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requirements.
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It is helpful to place project cash flows into three categories based on timing:
1. The initial cash outflow
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2. Interim incremental net cash flows
3. The terminal-year incremental net cash flow
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12 Capital Budgeting and Estimating Cash
Flows
Cash Flow Checklist
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MACRS Depreciation Percentages rs e
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12 Capital Budgeting and Estimating Cash
Flows
Questions
1. When relevant project cash flows are examined, why is an increase in tax
depreciation at first deducted and then later added back in determining
incremental net cash flow for a period?
2. In capital budgeting, should the following be ignored, or rather added or
subtracted from the new machine’s purchase price when estimating initial
cash outflow? When estimating the machine’s depreciable basis?
a. The market value of the old machine is $500, the old machine has a
remaining useful life, and the investment is a replacement decision.
b. An additional investment in inventory of $2,000 is required.
c. $200 is required to ship the new machine to the plant site.
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d. A concrete foundation for the new machine will cost $250.
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e. Training of the machine operator will cost $300.
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3. In determining the expected cash flows from a new investment project,
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why should past sunk costs be ignored in the estimates?
4. Discuss the adjustments in the capital budgeting process that should be
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made to compensate for expected inflation.
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5. What is the purpose of requiring more levels of management approval,
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the larger the proposed capital expenditure? Is more information also
required in support of the request?
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6. What is the difference between a product expansion and an equipment
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replacement investment?
Answers
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Refer the manual.
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12 Capital Budgeting and Estimating Cash
Flows
Problems
1. Thoma Pharmaceutical Company may buy DNA-testing equipment costing
$60,000. This equipment is expected to reduce labor costs of the clinical
staff by $20,000 annually. The equipment has a useful life of five years but
falls in the three-year property class for cost recovery (depreciation)
purposes. No salvage value is expected at the end. The corporate tax rate for
Thoma (combined federal and state) is 38 percent, and its required rate of
return is 15 percent. (If profits after taxes on the project are negative in any
year, the firm will offset the loss against other firm income for that year.) On
the basis of this information, what are the relevant cash flows?
2. In Problem 1, suppose that 6 percent inflation in savings from labor costs
is expected over the last four years, so that savings in the first year are
$20,000, savings in the second year are $21,200, and so forth.
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a. On the basis of this information, what are the relevant cash flows?
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b. If working capital of $10,000 were required in addition to the cost of the
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equipment and this additional investment were needed over the life of the
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project, what would be the effect on the relevant cash flows? (All other things
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are the same as in Problem 2, Part (a).)
3. The City of San Jose must replace a number of its concrete-mixer trucks
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with new trucks. It has received two bids and has evaluated closely the
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performance characteristics of the various trucks.
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The Rockbuilt truck, which costs $74,000, is top-of-the-line equipment. The
truck has a life of eight years, assuming that the engine is rebuilt in the fifth
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year. Maintenance costs of $2,000 a year are expected in the first four years,
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followed by total maintenance and rebuilding costs of $13,000 in the fifth
year. During the last three years, maintenance costs are expected to be
$4,000 a year. At the end of eight years the truck will have an estimated
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scrap value of $9,000.
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A bid from Bulldog Trucks, Inc., is for $59,000 a truck. Maintenance costs for
the truck will be higher. In the first year they are expected to be $3,000, and
this amount is expected to increase by $1,500 a year through the eighth
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year. In the fourth year the engine will need to be rebuilt, and this will cost
the company $15,000 in addition to maintenance costs in that year. At the
end of eight years the Bulldog truck will have an estimated scrap value of
$5,000.
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12 Capital Budgeting and Estimating Cash
Flows
a. What are the relevant cash flows related to the trucks of each bidder?
Ignore tax considerations because the City of San Jose pays no taxes.
b. Using the figures determined in Part (a), what are the cash-flow savings
each year that can be obtained by going with the more expensive truck
rather than the less expensive one? (That is, calculate the periodic cash-flow
differences between the two cash-flow streams – assume that any net cost
savings are positive benefits.)
4. US Blivet is contemplating the purchase of a more advanced blivet-
extrusion machine to replace the machine currently being used in its
production process. The firm’s production engineers contend that the newer
machine will turn out the current volume of output more efficiently. They
note the following facts in support of their contention.
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The old machine can be used for four more years. It has a current
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salvage value of $8,000, but if held to the end of its useful life, the old
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machine would have an estimated final salvage value of $2,000. This is
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the final year that tax depreciation will be taken on the machine, and the
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amount of depreciation is equal to the machine’s remaining depreciated
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(tax) book value of $4,520.
The new, advanced blivet-extrusion machine costs $60,000. Its final
salvage value is projected to be $15,000 at the end of its four-year useful
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life. The new machine falls into the three-year property category for
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MACRS depreciation.
The new machine will reduce labor and maintenance usage by $12,000
annually.
Income taxes on incremental profits are paid at a 40 percent rate.
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Calculate the expected annual incremental cash flows for years 1 through
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4, as well as the estimated initial cash outflow.
5. In Problem 4, suppose that you just discovered that the production
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engineers had slipped up twice in their statement of the relevant facts
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concerning the potential purchase of the new machine:
The engineers failed to note that in addition to the $60,000 invoice price
for the new machine, $2,000 must be paid for installation.
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The current salvage value of the old machine is not $8,000, but rather
only $3,000. On the basis of this new information, what are the relevant
cash flows for this replacement problem?
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12 Capital Budgeting and Estimating Cash
Flows
Solutions
Refer the manual
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