ńňđ. 1
(âńĺăî 2)

ŃÎÄĹĐĆŔÍČĹ

>>

Part

3
Long-Term
Investment
Decisions

Chapter 8
Capital Budgeting Cash Flows

Chapter 9
Capital Budgeting Techniques:
Certainty and Risk
Chapter Across the Disciplines


8
Why This Chapter Matters To You
Accounting: You need to understand cap-
ital budgeting cash flows in order to pro-
vide revenue, cost, depreciation, and tax
data for use both in monitoring existing
projects and in developing cash flows for

Capital proposed projects.
Information systems: You need to under-
stand capital budgeting cash flows in
Budgeting order to maintain and facilitate the
retrieval of cash flow data for both com-
pleted and existing projects.

Cash Flows Management: You need to understand
capital budgeting cash flows so that you
will understand what cash flows are rele-
vant in making decisions about proposals
for acquiring additional production facili-
ties, for new products, and for the expan-
sion of existing product lines.
Marketing: You need to understand capi-
LEARNING GOALS tal budgeting cash flows so that you can
make revenue estimates for proposals for
Understand the key motives for
LG1 new marketing programs, for new prod-
capital expenditure and the steps in
ucts, and for the expansion of existing
the capital budgeting process.
product lines.
Define basic capital budgeting
LG2
Operations: You need to understand capi-
terminology.
tal budgeting cash flows so that you can
Discuss the major components of make cost estimates for proposals for the
LG3
relevant cash flows, expansion versus
acquisition of new equipment and produc-
replacement cash flows, sunk costs
tion facilities.
and opportunity costs, and
international capital budgeting and
long-term investments.
Calculate the initial investment
LG4
associated with a proposed capital
expenditure.
Determine relevant operating cash
LG5
inflows using the income statement
format.
Find the terminal cash flow.
LG6




304
305
CHAPTER 8 Capital Budgeting Cash Flows



B efore committing resources to expand, replace, or renew fixed assets or to
undertake other types of long-term investments, firms carefully estimate and
analyze the expected costs and benefits associated with these expenditures. This
evaluation and selection process is called capital budgeting. We address this
important topic in finance in two chapters. This chapter describes important
aspects of the steps in the capital budgeting decision process and explains how
the key cash flows that are inputs to it are developed.



The Capital Budgeting Decision Process
LG1 LG2

Long-term investments represent sizable outlays of funds that commit a firm to
some course of action. Consequently, the firm needs procedures to analyze and
properly select its long-term investments. It must be able to measure cash flows
and apply appropriate decision techniques. As time passes, fixed assets may
become obsolete or may require an overhaul; at these points, too, financial deci-
sions may be required. Capital budgeting is the process of evaluating and select-
capital budgeting
The process of evaluating and ing long-term investments that are consistent with the firm’s goal of maximizing
selecting long-term investments owner wealth. Firms typically make a variety of long-term investments, but the
that are consistent with the
most common for the manufacturing firm is in fixed assets, which include prop-
firm’s goal of maximizing owner
erty (land), plant, and equipment. These assets, often referred to as earning
wealth.
assets, generally provide the basis for the firm’s earning power and value.
Because firms treat capital budgeting (investment) and financing decisions
separately, both this and the following chapter concentrate on fixed-asset acqui-
sition without regard to the specific method of financing used. We begin by dis-
cussing the motives for capital expenditure.


Motives for Capital Expenditure
A capital expenditure is an outlay of funds by the firm that is expected to produce
capital expenditure
An outlay of funds by the firm that benefits over a period of time greater than 1 year. An operating expenditure is an
is expected to produce benefits outlay resulting in benefits received within 1 year. Fixed-asset outlays are capital
over a period of time greater than
expenditures, but not all capital expenditures are classified as fixed assets. A
1 year.
$60,000 outlay for a new machine with a usable life of 15 years is a capital
operating expenditure expenditure that would appear as a fixed asset on the firm’s balance sheet. A
An outlay of funds by the firm
$60,000 outlay for advertising that produces benefits over a long period is also a
resulting in benefits received
capital expenditure, but would rarely be shown as a fixed asset.
within 1 year.
Capital expenditures are made for many reasons. The basic motives for capi-
tal expenditures are to expand, replace, or renew fixed assets or to obtain some
other, less tangible benefit over a long period. Table 8.1 briefly describes the key
motives for making capital expenditures.


Steps in the Process
capital budgeting process
The capital budgeting process consists of five distinct but interrelated steps.
Five distinct but interrelated
steps: proposal generation,
1. Proposal generation. Proposals are made at all levels within a business orga-
review and analysis, decision
nization and are reviewed by finance personnel. Proposals that require large
making, implementation, and
outlays are more carefully scrutinized than less costly ones.
follow-up.
306 PART 3 Long-Term Investment Decisions


TABLE 8.1 Key Motives for Making Capital Expenditures

Motive Description

Expansion The most common motive for a capital expenditure is to expand the level
of operations—usually through acquisition of fixed assets. A growing
firm often needs to acquire new fixed assets rapidly, as in the purchase
of property and plant facilities.

Replacement As a firm’s growth slows and it reaches maturity, most capital expendi-
tures will be made to replace or renew obsolete or worn-out assets. Each
time a machine requires a major repair, the outlay for the repair should
be compared to the outlay to replace the machine and the benefits of
replacement.

Renewal Renewal, an alternative to replacement, may involve rebuilding, over-
hauling, or retrofitting an existing fixed asset. For example, an existing
drill press could be renewed by replacing its motor and adding a numeric
control system, or a physical facility could be renewed by rewiring and
adding air conditioning. To improve efficiency, both replacement and
renewal of existing machinery may be suitable solutions.

Other purposes Some capital expenditures do not result in the acquisition or transforma-
tion of tangible fixed assets. Instead, they involve a long-term commit-
ment of funds in expectation of a future return. These expenditures
include outlays for advertising, research and development, management
consulting, and new products. Other capital expenditure proposals—such
as the installation of pollution-control and safety devices mandated by
the government—are difficult to evaluate because they provide intangible
returns rather than clearly measurable cash flows.




2. Review and analysis. Formal review and analysis is performed to assess the
appropriateness of proposals and evaluate their economic viability. Once the
analysis is complete, a summary report is submitted to decision makers.
3. Decision making. Firms typically delegate capital expenditure decision mak-
ing on the basis of dollar limits. Generally, the board of directors must
authorize expenditures beyond a certain amount. Often plant managers are
given authority to make decisions necessary to keep the production line
moving.
4. Implementation. Following approval, expenditures are made and projects
implemented. Expenditures for a large project often occur in phases.
5. Follow-up. Results are monitored, and actual costs and benefits are com-
pared with those that were expected. Action may be required if actual out-
comes differ from projected ones.

Each step in the process is important. Review and analysis and decision mak-
ing (Steps 2 and 3) consume the majority of time and effort, however. Follow-up
(Step 5) is an important but often ignored step aimed at allowing the firm to
improve the accuracy of its cash flow estimates continuously. Because of their
fundamental importance, this and the following chapters give primary considera-
tion to review and analysis and to decision making.
307
CHAPTER 8 Capital Budgeting Cash Flows


Basic Terminology
Before we develop the concepts, techniques, and practices related to the capital
budgeting process, we need to explain some basic terminology. In addition, we
will present some key assumptions that are used to simplify the discussion in the
remainder of this chapter and in Chapter 9.

Independent versus Mutually Exclusive Projects
The two most common types of projects are (1) independent projects and (2)
mutually exclusive projects. Independent projects are those whose cash flows are
independent projects
Projects whose cash flows are unrelated or independent of one another; the acceptance of one does not elimi-
unrelated or independent of one nate the others from further consideration. Mutually exclusive projects are those
another; the acceptance of one
that have the same function and therefore compete with one another. The accep-
does not eliminate the others
tance of one eliminates from further consideration all other projects that serve a
from further consideration.
similar function. For example, a firm in need of increased production capacity
mutually exclusive projects
could obtain it by (1) expanding its plant, (2) acquiring another company, or (3)
Projects that compete with one
contracting with another company for production. Clearly, accepting any one
another, so that the acceptance
option eliminates the need for either of the others.
of one eliminates from further
consideration all other projects
that serve a similar function. Unlimited Funds versus Capital Rationing
The availability of funds for capital expenditures affects the firm’s decisions. If a
firm has unlimited funds for investment, making capital budgeting decisions is
unlimited funds
The financial situation in which quite simple: All independent projects that will provide an acceptable return can
a firm is able to accept all
be accepted. Typically, though, firms operate under capital rationing instead.
independent projects that
This means that they have only a fixed number of dollars available for capital
provide an acceptable return.
expenditures and that numerous projects will compete for these dollars. Proce-
capital rationing dures for dealing with capital rationing are presented in Chapter 9. The discus-
The financial situation in which
sions that follow in this chapter assume unlimited funds.
a firm has only a fixed number of
dollars available for capital
Accept–Reject versus Ranking Approaches
expenditures, and numerous
projects compete for these
Two basic approaches to capital budgeting decisions are available. The accept–
dollars.
reject approach involves evaluating capital expenditure proposals to determine
accept–reject approach
whether they meet the firm’s minimum acceptance criterion. This approach can
The evaluation of capital
be used when the firm has unlimited funds, as a preliminary step when evaluating
expenditure proposals to
mutually exclusive projects, or in a situation in which capital must be rationed. In
determine whether they meet the
these cases, only acceptable projects should be considered.
firm’s minimum acceptance
criterion. The second method, the ranking approach, involves ranking projects on the
basis of some predetermined measure, such as the rate of return. The project with
ranking approach
the highest return is ranked first, and the project with the lowest return is ranked
The ranking of capital expendi-
ture projects on the basis of last. Only acceptable projects should be ranked. Ranking is useful in selecting the
some predetermined measure,
“best” of a group of mutually exclusive projects and in evaluating projects with a
such as the rate of return.
view to capital rationing.

Conventional versus Nonconventional Cash Flow Patterns
Cash flow patterns associated with capital investment projects can be classified as
conventional cash flow pattern
conventional or nonconventional. A conventional cash flow pattern consists of
An initial outflow followed only
an initial outflow followed only by a series of inflows. For example, a firm may
by a series of inflows.
308 PART 3 Long-Term Investment Decisions


FIGURE 8.1
$2,000 $2,000 $2,000 $2,000
Conventional Cash Flow $2,000 $2,000 $2,000 $2,000
Time line for a conventional
cash flow pattern
Cash Inflows
0
1 2 3 4 5 6 7 8
Cash Outflows


$10,000
End of Year




spend $10,000 today and as a result expect to receive equal annual cash inflows
(an annuity) of $2,000 each year for the next 8 years, as depicted on the time line
in Figure 8.1.1 A conventional cash flow pattern that provides unequal annual
cash inflows is depicted in Figure 8.3 on page 310.
A nonconventional cash flow pattern is one in which an initial outflow is fol-
nonconventional
lowed by a series of inflows and outflows. For example, the purchase of a machine
cash flow pattern
An initial outflow followed by a may require an initial cash outflow of $20,000 and may generate cash inflows of
series of inflows and outflows.
$5,000 each year for 4 years. In the fifth year after purchase, an outflow of $8,000
may be required to overhaul the machine, after which it generates inflows of
$5,000 each year for 5 more years. This nonconventional pattern is illustrated on
the time line in Figure 8.2.
Difficulties often arise in evaluating projects with nonconventional patterns
of cash flow. The discussions in the remainder of this chapter and in Chapter 9 are
therefore limited to the evaluation of conventional cash flow patterns.




FIGURE 8.2
$5,000 $5,000 $5,000 $5,000
Nonconventional $5,000 $5,000 $5,000 $5,000 $5,000
Cash Flow
Time line for a nonconven-
Cash Inflows
tional cash flow pattern 0 5
1 2 3 4 6 7 8 9 10
Cash Outflows


$20,000 $8,000

End of Year




1. Arrows rather than plus or minus signs are frequently used on time lines to distinguish between cash inflows and
cash outflows. Upward-pointing arrows represent cash inflows (positive cash flows), and downward-pointing
arrows represent cash outflows (negative cash flows).
309
CHAPTER 8 Capital Budgeting Cash Flows


Review Questions

8–1 What is capital budgeting? Do all capital expenditures involve fixed
assets? Explain.
8–2 What are the key motives for making capital expenditures? Discuss, com-
pare, and contrast them.
8–3 What are the five steps involved in the capital budgeting process?
8–4 Differentiate between the members of each of the following pairs of capi-
tal budgeting terms: (a) independent versus mutually exclusive projects;
(b) unlimited funds versus capital rationing; (c) accept–reject versus rank-
ing approaches; and (d) conventional versus nonconventional cash flow
patterns.



The Relevant Cash Flows
LG3


To evaluate capital expenditure alternatives, the firm must determine the relevant
relevant cash flows
The incremental cash outflow cash flows. These are the incremental cash outflow (investment) and resulting
(investment) and resulting subse- subsequent inflows. The incremental cash flows represent the additional cash
quent inflows associated with a
flows—outflows or inflows—expected to result from a proposed capital expendi-
proposed capital expenditure.
ture. As noted in Chapter 3, cash flows rather than accounting figures are used,
incremental cash flows because cash flows directly affect the firm’s ability to pay bills and purchase
The additional cash flows—
assets. The remainder of this chapter is devoted to the procedures for measuring
outflows or inflows—expected
the relevant cash flows associated with proposed capital expenditures.
to result from a proposed capital
expenditure.

Major Cash Flow Components
The cash flows of any project having the conventional pattern can include three
basic components: (1) an initial investment, (2) operating cash inflows, and (3)
terminal cash flow. All projects—whether for expansion, replacement, renewal,
initial investment or some other purpose—have the first two components. Some, however, lack the
The relevant cash outflow for a
final component, terminal cash flow.
proposed project at time zero.
Figure 8.3 depicts on a time line the cash flows for a project. The initial invest-
operating cash inflows ment for the proposed project is $50,000. This is the relevant cash outflow at time
The incremental after-tax cash
zero. The operating cash inflows, which are the incremental after-tax cash inflows
inflows resulting from implemen-
resulting from implementation of the project during its life, gradually increase
tation of a project during its life.
from $4,000 in its first year to $10,000 in its tenth and final year. The terminal
terminal cash flow cash flow is the after-tax nonoperating cash flow occurring in the final year of the
The after-tax nonoperating cash
project. It is usually attributable to liquidation of the project. In this case it is
flow occurring in the final year of
$25,000, received at the end of the project’s 10-year life. Note that the terminal
a project. It is usually attribut-
cash flow does not include the $10,000 operating cash inflow for year 10.
able to liquidation of the project.



Expansion versus Replacement Cash Flows
Developing relevant cash flow estimates is most straightforward in the case of
expansion decisions. In this case, the initial investment, operating cash inflows,
and terminal cash flow are merely the after-tax cash outflow and inflows associ-
ated with the proposed capital expenditure.
310 PART 3 Long-Term Investment Decisions


FIGURE 8.3
Terminal
Cash Flow Components Cash Flow
Time line for major cash flow
components $25,000
Operating
Cash Inflows

$5,000 $7,000 $8,000 $8,000 $10,000
$4,000 $6,000 $7,000 $8,000 $9,000


0
1 2 3 4 5 6 7 8 9 10


$50,000
End of Year
Initial
Investment




Identifying relevant cash flows for replacement decisions is more compli-
cated, because the firm must identify the incremental cash outflow and inflows
that would result from the proposed replacement. The initial investment in the
case of replacement is the difference between the initial investment needed to
acquire the new asset and any after-tax cash inflows expected from liquidation of
the old asset. The operating cash inflows are the difference between the operating
cash inflows from the new asset and those from the old asset. The terminal cash
flow is the difference between the after-tax cash flows expected upon termination
of the new and the old assets. These relationships are shown in Figure 8.4.


FIGURE 8.4
Initial investment After-tax cash inflows
Initial
needed to acquire from liquidation
Relevant Cash Flows for investment
new asset of old asset
Replacement Decisions
Calculation of the three
components of relevant cash
flow for a replacement
Operating cash Operating cash
decision Operating
inflows from inflows from
cash inflows
new asset old asset




After-tax cash flows After-tax cash flows
Terminal
from termination from termination
cash flow
of new asset of old asset
311
CHAPTER 8 Capital Budgeting Cash Flows



In Practice
FOCUS ON e-FINANCE Chipping Away at E-Business
Investment Analysis
It should come as no surprise that Ironically, Bryant’s skepticism employees could focus on analy-
Intel, the world’s largest chip about e-commerce turned out to sis. Bryant estimates that the pres-
maker and technology pioneer, is be a good thing. He developed ent value of this project’s cash
also a leader in e-business. Chair- methods to analyze e-business inflows, less the initial investment,
man Andy Grove decided in 1998 proposals to make sure they added is $8 million. And the company no
that Intel would transform itself value to the company, applying rig- longer misses opportunities to take
into a “100 percent e-corporation.” orous financial discipline and mon- advantage of discounts for prompt
Since then, each of the company’s itoring returns on investment. payments.
new business applications has “Every project has an ROI,” Bryant Like Intel, every firm must
been based on the Internet or on says. “It isn’t always positive, but evaluate the costs and returns of
e-commerce. Leading the Internet you still have to measure what you projects for expansion, asset
initiative was CFO Andy Bryant, put in and what you get back.” replacement or renewal, research
whose responsibilities were The difficulty comes in decid- and development, advertising, and
expanded to include enterprise ing what to measure—and how. other areas that require long-term
services. Like most companies, Intel already commitments of funds in expecta-
Bryant was an unlikely choice had expertise in evaluating new tion of future returns. The first step
to lead the company’s transforma- manufacturing facilities and other in evaluating projects involves the
tion, because he was skeptical capital projects. But technology identification of the relevant cash
about the value of e-commerce. He projects also have intangible ben- outflows and inflows that must be
quickly changed his tune when he efits that aren’t easily quantified. considered in making the invest-
learned that Intel receives over One of Bryant’s challenges was ment decision.
one-quarter of its orders after formalizing financial accountability
hours. The flexibility of online for e-business applications. Sources: Annual Report 2000, Intel Corpora-
ordering added value for cus- The company’s track record tion, downloaded from www.intel.com;
Shari Caudron, “The Tao of E-Business,”
tomers. Intel has launched more has been quite good so far. E-busi- Business Finance, September 2001, down-
than 300 e-business projects since ness projects have reduced costs loaded from www. businessfinance.com;
and Tim Reason, “How E-Business Trans-
1998. In 2001, the company gener- in many areas. For example, an
formed Intel and CFO Andy Bryant,” CFO,
ated 90 percent of its revenue— electronic accounts payable (A/P) October 2001, downloaded from
$31.4 billion—from e-commerce system was devised to take over www.cfo.com.
transactions. many routine transactions so that




Actually, all capital budgeting decisions can be viewed as replacement deci-
sions. Expansion decisions are merely replacement decisions in which all cash
flows from the old asset are zero. In light of this fact, this chapter focuses primar-
ily on replacement decisions.


Sunk Costs and Opportunity Costs
When estimating the relevant cash flows associated with a proposed capital
expenditure, the firm must recognize any sunk costs and opportunity costs. These
sunk costs costs are easy to mishandle or ignore, particularly when determining a project’s
Cash outlays that have already
incremental cash flows. Sunk costs are cash outlays that have already been made
been made (past outlays) and
(past outlays) and therefore have no effect on the cash flows relevant to the cur-
therefore have no effect on the
rent decision. As a result, sunk costs should not be included in a project’s incre-
cash flows relevant to a current
mental cash flows.
decision.
312 PART 3 Long-Term Investment Decisions


Opportunity costs are cash flows that could be realized from the best alterna-
opportunity costs
Cash flows that could be realized tive use of an owned asset. They therefore represent cash flows that will not be
from the best alternative use of realized as a result of employing that asset in the proposed project. Because of
an owned asset.
this, any opportunity costs should be included as cash outflows when one is
determining a project’s incremental cash flows.

Jankow Equipment is considering renewing its drill press X12, which it purchased
EXAMPLE
3 years earlier for $237,000, by retrofitting it with the computerized control sys-
tem from an obsolete piece of equipment it owns. The obsolete equipment could
be sold today for a high bid of $42,000, but without its computerized control sys-
tem, it would be worth nothing. Jankow is in the process of estimating the labor
and materials costs of retrofitting the system to drill press X12 and the benefits
expected from the retrofit. The $237,000 cost of drill press X12 is a sunk cost
because it represents an earlier cash outlay. It would not be included as a cash out-
flow when determining the cash flows relevant to the retrofit decision. Although
Jankow owns the obsolete piece of equipment, the proposed use of its computer-
ized control system represents an opportunity cost of $42,000—the highest price
at which it could be sold today. This opportunity cost would be included as a cash
outflow associated with using the computerized control system.



International Capital Budgeting
and Long-Term Investments
Although the same basic capital budgeting principles are used for domestic and
international projects, several additional factors must be addressed in evaluating
foreign investment opportunities. International capital budgeting differs from the
domestic version because (1) cash outflows and inflows occur in a foreign cur-
rency, and (2) foreign investments entail potentially significant political risk. Both
of these risks can be minimized through careful planning.
Companies face both long-term and short-term currency risks related to both
the invested capital and the cash flows resulting from it. Long-term currency risk
can be minimized by financing the foreign investment at least partly in the local
capital markets rather than with dollar-denominated capital from the parent
company. This step ensures that the project’s revenues, operating costs, and
financing costs will be in the local currency. Likewise, the dollar value of short-
term, local-currency cash flows can be protected by using special securities and
strategies such as futures, forwards, and options market instruments.
Political risks can be minimized by using both operating and financial strate-
gies. For example, by structuring the investment as a joint venture and selecting a
well-connected local partner, the U.S. company can minimize the risk of its oper-
ations being seized or harassed. Companies also can protect themselves from hav-
ing their investment returns blocked by local governments by structuring the
financing of such investments as debt rather than as equity. Debt-service pay-
ments are legally enforceable claims, whereas equity returns (such as dividends)
are not. Even if local courts do not support the claims of the U.S. company, the
foreign direct investment
company can threaten to pursue its case in U.S. courts.
The transfer of capital, manager-
In spite of the preceding difficulties, foreign direct investment, which involves
ial, and technical assets to a
the transfer of capital, managerial, and technical assets to a foreign country, has
foreign country.
313
CHAPTER 8 Capital Budgeting Cash Flows


surged in recent years. This is evident in the growing market values of foreign
assets owned by U.S.-based companies and of foreign direct investment in the
United States, particularly by British, Canadian, Dutch, German, and Japanese
companies. Furthermore, foreign direct investment by U.S. companies seems to
be accelerating.


Review Questions

8–5 Why is it important to evaluate capital budgeting projects on the basis of
incremental cash flows?
8–6 What three components of cash flow may exist for a given project? How
can expansion decisions be treated as replacement decisions? Explain.
8–7 What effect do sunk costs and opportunity costs have on a project’s incre-
mental cash flows?
8–8 How can currency risk and political risk be minimized when one is mak-
ing foreign direct investment?



Finding the Initial Investment
LG4

The term initial investment as used here refers to the relevant cash outflows to be
considered when evaluating a prospective capital expenditure. Because our discus-
sion of capital budgeting is concerned only with investments that exhibit conven-
tional cash flows, the initial investment occurs at time zero—the time at which the
expenditure is made. The initial investment is calculated by subtracting all cash
inflows occurring at time zero from all cash outflows occurring at time zero.
The basic format for determining the initial investment is given in Table 8.2.
The cash flows that must be considered when determining the initial investment
associated with a capital expenditure are the installed cost of the new asset, the
after-tax proceeds (if any) from the sale of an old asset, and the change (if any) in
net working capital. Note that if there are no installation costs and the firm is not


TABLE 8.2 The Basic Format
for Determining
Initial Investment

Installed cost of new asset
Cost of new asset
Installation costs
After-tax proceeds from sale of old asset
Proceeds from sale of old asset
Tax on sale of old asset
Change in net working capital
Initial investment
314 PART 3 Long-Term Investment Decisions


replacing an existing asset, then the purchase price of the asset, adjusted for any
change in net working capital, is equal to the initial investment.


Installed Cost of New Asset
As shown in Table 8.2, the installed cost of the new asset is found by adding the
cost of new asset
cost of the new asset to its installation costs. The cost of new asset is the net out-
The net outflow necessary to
flow that its acquisition requires. Usually, we are concerned with the acquisition
acquire a new asset.
of a fixed asset for which a definite purchase price is paid. Installation costs are
installation costs
any added costs that are necessary to place an asset into operation. The Internal
Any added costs that are
Revenue Service (IRS) requires the firm to add installation costs to the purchase
necessary to place an asset into
price of an asset to determine its depreciable value, which is expensed over a
operation.
period of years. The installed cost of new asset, calculated by adding the cost of
installed cost of new asset
the asset to its installation costs, equals its depreciable value.
The cost of the asset plus its
installation costs; equals the
asset’s depreciable value.

After-Tax Proceeds
after-tax proceeds
from Sale of Old Asset
from sale of old asset
The difference between the old
Table 8.2 shows that the after-tax proceeds from sale of old asset decrease the
asset’s sale proceeds and any
applicable taxes or tax refunds firm’s initial investment in the new asset. These proceeds are the difference
related to its sale.
between the old asset’s sale proceeds and any applicable taxes or tax refunds
related to its sale. The proceeds from sale of old asset are the net cash inflows it pro-
proceeds from sale of old asset
The cash inflows, net of any vides. This amount is net of any costs incurred in the process of removing the asset.
removal or cleanup costs, result-
Included in these removal costs are cleanup costs, such as those related to removal
ing from the sale of an existing
and disposal of chemical and nuclear wastes. These costs may not be trivial.
asset.
The proceeds from the sale of an old asset are normally subject to some type of
tax on sale of old asset tax. 2 This tax on sale of old asset depends on the relationship among its sale price,
Tax that depends on the relation-
initial purchase price, and book value, and on existing government tax rules.
ship among the old asset’s sale
price, initial purchase price, and
book value, and on existing
Book Value
government tax rules.

The book value of an asset is its strict accounting value. It can be calculated by
book value
The strict accounting value of an using the following equation:
asset, calculated by subtracting
Book value Installed cost of asset Accumulated depreciation (8.1)
its accumulated depreciation
from its installed cost.

Hudson Industries, a small electronics company, 2 years ago acquired a machine
EXAMPLE
tool with an installed cost of $100,000. The asset was being depreciated under
MACRS using a 5-year recovery period.3 Table 3.2 (page 89) shows that under
MACRS for a 5-year recovery period, 20% and 32% of the installed cost would
be depreciated in years 1 and 2, respectively. In other words, 52% (20% 32%)



2. A brief discussion of the tax treatment of ordinary and capital gains income was presented in Chapter 1.
3. For a review of MACRS, see Chapter 3. Under current tax law, most manufacturing equipment has a 7-year
recovery period, as noted in Table 3.1. Using this recovery period results in 8 years of depreciation, which unneces-
sarily complicates examples and problems. To simplify, manufacturing equipment is treated as a 5-year asset in this
and the following chapter.
315
CHAPTER 8 Capital Budgeting Cash Flows


of the $100,000 cost, or $52,000 (0.52 $100,000), would represent the accu-
mulated depreciation at the end of year 2. Substituting into Equation 8.1, we get
Book value $100,000 $52,000 $48,000

The book value of Hudson’s asset at the end of year 2 is therefore $48,000.


Basic Tax Rules
Four potential tax situations can occur when an asset is sold. These situations
depend on the relationship between the asset’s sale price, its initial purchase
price, and its book value. The three key forms of taxable income and their associ-
ated tax treatments are defined and summarized in Table 8.3. The assumed tax
rates used throughout this text are noted in the final column. There are four pos-
sible tax situations, which result in one or more forms of taxable income: The
asset may be sold (1) for more than its initial purchase price, (2) for more than its
book value but less than its initial purchase price, (3) for its book value, or (4) for
less than its book value. An example will illustrate.

The old asset purchased 2 years ago for $100,000 by Hudson Industries has a
EXAMPLE
current book value of $48,000. What will happen if the firm now decides to sell
the asset and replace it? The tax consequences depend on the sale price. Figure
8.5 on page 316 depicts the taxable income resulting from four possible sale
prices in light of the asset’s initial purchase price of $100,000 and its current
book value of $48,000. The taxable consequences of each of these sale prices is
described below.

The sale of the asset for more than its initial purchase price If Hudson sells the
old asset for $110,000, it realizes a capital gain of $10,000, which is taxed as



TABLE 8.3 Tax Treatment on Sales of Assets

Form of taxable income Definition Tax treatment Assumed tax rate

Capital gain Portion of the sale price that is in Regardless of how long the asset 40%
excess of the initial purchase price. has been held, the total capital gain
is taxed as ordinary income.
Recaptured depreciation Portion of the sale price that is in All recaptured depreciation is taxed 40%
excess of book value and represents as ordinary income.
a recovery of previously taken
depreciation.
Loss on sale of asset Amount by which sale price is less If the asset is depreciable and used 40% of loss is a
than book value. in business, loss is deducted from tax savings
ordinary income.
If the asset is not depreciable or 40% of loss is a
is not used in business, loss is tax savings
deductible only against capital
gains.
316 PART 3 Long-Term Investment Decisions


FIGURE 8.5 Taxable Income from Sale of Asset
Taxable income from sale of asset at various sale prices for Hudson Industries

Sale Price
$110,000 $70,000 $48,000 $30,000


Capital Gain
$110,000
Initial ($10,000)
$100,000
Purchase
Price
Recaptured
Depreciation
($52,000)
$70,000
Recaptured
Depreciation
($22,000)
Book No Gain
$48,000
Value or Loss
Loss
($18,000)
$30,000



$0




ordinary income.4 The firm also experiences ordinary income in the form of
recaptured depreciation, which is the portion of the sale price that is above book
recaptured depreciation
The portion of an asset’s sale value and below the initial purchase price. In this case there is recaptured depreci-
price that is above its book ation of $52,000 ($100,000 $48,000). Both the $10,000 capital gain and the
value and below its initial
$52,000 recaptured depreciation are shown under the $110,000 sale price in Fig-
purchase price.
ure 8.5. The taxes on the total gain of $62,000 are calculated as follows:


Tax
Amount Rate [(1) (2)]
(1) (2) (3)

Capital gain $10,000 0.40 $24,000
Recaptured depreciation 52,000 0.40 20,800
Totals $62,000 $24,800



These taxes should be used in calculating the initial investment in the new asset,
using the format in Table 8.2. In effect, the taxes raise the amount of the firm’s
initial investment in the new asset by reducing the proceeds from the sale of the
old asset.



4. Although the current tax law requires corporate capital gains to be treated as ordinary income, the structure for
corporate capital gains is retained under the law to facilitate a rate differential in the likely event of future tax revi-
sions. Therefore, this distinction is made throughout the text discussions.
317
CHAPTER 8 Capital Budgeting Cash Flows


The sale of the asset for more than its book value but less than its initial purchase
price If Hudson sells the old asset for $70,000, there is no capital gain. However,
the firm still experiences a gain in the form of recaptured depreciation of $22,000
($70,000 $48,000), as shown under the $70,000 sale price in Figure 8.5. This
recaptured depreciation is taxed as ordinary income. Because the firm is assumed to
be in the 40% tax bracket, the taxes on the $22,000 gain are $8,800. This amount
in taxes should be used in calculating the initial investment in the new asset.

The sale of the asset for its book value If the asset is sold for $48,000, its book
value, the firm breaks even. There is no gain or loss, as shown under the $48,000
sale price in Figure 8.5. Because no tax results from selling an asset for its book
value, there is no tax effect on the initial investment in the new asset.

The sale of the asset for less than its book value If Hudson sells the asset for
$30,000, it experiences a loss of $18,000 ($48,000 $30,000), as shown under
the $30,000 sale price in Figure 8.5. If this is a depreciable asset used in the busi-
ness, the loss may be used to offset ordinary operating income. If the asset is not
depreciable or is not used in the business, the loss can be used only to offset capital
gains. In either case, the loss will save the firm $7,200 ($18,000 0.40) in taxes.
And, if current operating earnings or capital gains are not sufficient to offset the
loss, the firm may be able to apply these losses to prior or future years’ taxes.5


Change in Net Working Capital
Net working capital is the amount by which a firm’s current assets exceed its cur-
net working capital
The amount by which a firm’s rent liabilities. This topic is treated in depth in Chapter 13, but at this point it is
current assets exceed its current
important to note that changes in net working capital often accompany capital
liabilities.
expenditure decisions. If a firm acquires new machinery to expand its level of
operations, it will experience an increase in levels of cash, accounts receivable,
inventories, accounts payable, and accruals. These increases result from the need
for more cash to support expanded operations, more accounts receivable and
inventories to support increased sales, and more accounts payable and accruals to
support increased outlays made to meet expanded product demand. As noted in
Chapter 3, increases in cash, accounts receivable, and inventories are outflows of
cash, whereas increases in accounts payable and accruals are inflows of cash.
The difference between the change in current assets and the change in current
liabilities is the change in net working capital. Generally, current assets increase
change in net working capital
The difference between a change by more than current liabilities, resulting in an increased investment in net work-
in current assets and a change in ing capital. This increased investment is treated as an initial outflow. If the
current liabilities.
change in net working capital were negative, it would be shown as an initial
inflow. The change in net working capital—regardless of whether it is an increase
or a decrease—is not taxable because it merely involves a net buildup or net
reduction of current accounts.

Danson Company, a metal products manufacturer, is contemplating expanding its
EXAMPLE
operations. Financial analysts expect that the changes in current accounts summa-



5. The tax law provides detailed procedures for using tax loss carrybacks/carryforwards. Application of such proce-
dures to capital budgeting is beyond the scope of this text, and they are therefore ignored in subsequent discussions.
318 PART 3 Long-Term Investment Decisions


TABLE 8.4 Calculation of Change
in Net Working Capital
for Danson Company

Current account Change in balance

Cash $ 4,000
Accounts receivable 10,000
Inventories 8,000
(1) Current assets $22,000
Accounts payable $ 7,000
Accruals 2,000
(2) Current liabilities 9,000
Change in net working capital [(1) (2)] $13,000




rized in Table 8.4 will occur and will be maintained over the life of the expansion.
Current assets are expected to increase by $22,000, and current liabilities are
expected to increase by $9,000, resulting in a $13,000 increase in net working cap-
ital. In this case, the increase will represent an increased net working capital invest-
ment and will be treated as a cash outflow in calculating the initial investment.


Calculating the Initial Investment
A variety of tax and other considerations enter into the initial investment calcula-
tion. The following example illustrates calculation of the initial investment
according to the format in Table 8.2.

Powell Corporation, a large, diversified manufacturer of aircraft components, is
EXAMPLE
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 present (old) machine was pur-
chased 3 years ago at a cost of $240,000 and was being 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 to remove it at the buyer’s expense.
The firm expects that a $35,000 increase in current assets and an $18,000
increase in current liabilities will accompany the replacement; these changes will
result in a $17,000 ($35,000 $18,000) increase in net working capital. Both
ordinary income and capital gains are taxed at a rate of 40%.
The only component of the initial investment calculation that is difficult to
obtain is taxes. Because the firm is planning to sell the present machine for
$40,000 more than its initial purchase price, a capital gain of $40,000 will be
realized. The book value of the present machine can be found by using the depre-
ciation percentages from Table 3.2 (page 89) of 20%, 32%, and 19% for years 1,
2, and 3, respectively. The resulting book value is $69,600 ($240,000 [(0.20
0.32 0.19) $240,000]). An ordinary gain of $170,400 ($240,000 $69,600)
319
CHAPTER 8 Capital Budgeting Cash Flows


in recaptured depreciation is also realized on the sale. The total taxes on the gain
are $84,160 [($40,000 $170,400) 0.40]. Substituting these amounts into the
format in Table 8.2 results in an initial investment of $221,160, which represents
the net cash outflow required at time zero.
Installed cost of proposed machine
Cost of proposed machine $380,000
Installation costs 20,000
Total installed cost—proposed
(depreciable value) $400,000
After-tax proceeds from sale of present machine
Proceeds from sale of present machine $280,000
Tax on sale of present machine 84,160
Total after-tax proceeds—present 195,840
Change in net working capital 17,000
Initial investment $221,160


Review Questions

8–9 Explain how each of the following inputs is used to calculate the initial in-
vestment: (a) cost of new asset, (b) installation costs, (c) proceeds from sale
of old asset, (d) tax on sale of old asset, and (e) change in net working capital.
8–10 How is the book value of an asset calculated? What are the three key
forms of taxable income?
8–11 What four tax situations may result from the sale of an asset that is being
replaced?
8–12 Referring to the basic format for calculating initial investment, explain
how a firm would determine the depreciable value of the new asset.



Finding the Operating Cash Inflows
LG5

The benefits expected from a capital expenditure or “project” are embodied in its
operating cash inflows, which are incremental after-tax cash inflows. In this sec-
tion we use the income statement format to develop clear definitions of the terms
after-tax, cash inflows, and incremental.


Interpreting the Term After-Tax
Benefits expected to result from proposed capital expenditures must be measured
on an after-tax basis, because the firm will not have the use of any benefits until it
has satisfied the government’s tax claims. These claims depend on the firm’s tax-
able income, so deducting taxes before making comparisons between proposed
investments is necessary for consistency when evaluating capital expenditure
alternatives.
320 PART 3 Long-Term Investment Decisions


Interpreting the Term Cash Inflows
All benefits expected from a proposed project must be measured on a cash flow
basis. Cash inflows represent dollars that can be spent, not merely “accounting
profits.” A simple accounting technique for converting after-tax net profits into
operating cash inflows was given in Equation 3.1 on page 90. The basic calcula-
tion requires adding depreciation and any other noncash charges (amortization
and depletion) deducted as expenses on the firm’s income statement back to net
profits after taxes. Because depreciation is commonly found on income state-
ments, it is the only noncash charge we consider.

Powell Corporation’s estimates of its revenue and expenses (excluding deprecia-
EXAMPLE
tion), with and without the proposed 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 present 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.
The proposed machine is to be depreciated under MACRS using a 5-year recov-
ery period.6 The resulting depreciation on this machine for each of the 6 years, as
well as the remaining 3 years of depreciation (years 4, 5, and 6) on the present
machine, are calculated in Table 8.6.7
The operating cash inflows in each year can be calculated by using the
income statement format shown in Table 8.7. Substituting the data from Tables
8.5 and 8.6 into this format and assuming a 40% tax rate, we get Table 8.8. It
demonstrates the calculation of operating cash inflows for each year for both the
proposed and the present machine. Because the proposed machine is depreciated



TABLE 8.5 Powell Corporation’s Revenue and Expenses
(Excluding Depreciation) for Proposed and
Present Machines

With proposed machine With present machine

Expenses Expenses
Revenue (excl. depr.) Revenue (excl. depr.)
Year (1) (2) Year (1) (2)

1 $2,520,000 $2,300,000 1 $2,200,000 $1,990,000
2 2,520,000 2,300,000 2 2,300,000 2,110,000
3 2,520,000 2,300,000 3 2,400,000 2,230,000
4 2,520,000 2,300,000 4 2,400,000 2,250,000
5 2,520,000 2,300,000 5 2,250,000 2,120,000




6. As noted in Chapter 3, it takes n 1 years to depreciate an n-year class asset under current tax law. Therefore,
MACRS percentages are given for each of 6 years for use in depreciating an asset with a 5-year recovery period.
7. It is important to recognize that although both machines will provide 5 years of use, the proposed new machine
will be depreciated over the 6-year period, whereas the present machine, as noted in the preceding example, has been
depreciated over 3 years and therefore has remaining only its final 3 years (years 4, 5, and 6) of depreciation (12%,
12%, and 5%, respectively, under MACRS).
321
CHAPTER 8 Capital Budgeting Cash Flows


TABLE 8.6 Depreciation Expense for Proposed and Present
Machines for Powell Corporation

Applicable MACRS depreciation Depreciation
Cost percentages (from Table 3.2) [(1) (2)]
Year (1) (2) (3)

With proposed machine

1 $400,000 20% $ 80,000
2 400,000 32 128,000
3 400,000 19 76,000
4 400,000 12 48,000
5 400,000 12 48,000
6 400,000 5 20,000
Totals 100% $400,000

With present machine

1 $240,000 12% (year-4 depreciation) $28,800
2 240,000 12 (year-5 depreciation) 28,800
3 240,000 5 (year-6 depreciation) 12,000
4 0
Because the present machine is at the end of the third year of its cost recovery at
5 0
the time the analysis is performed, it has only the final 3 years of depreciation
(as noted above) still applicable.
6 0
$69,600a
Total
aThe total $69,600 represents the book value of the present machine at the end of the third year, as calcu-
lated in the preceding example.




TABLE 8.7 Calculation of Operating
Cash Inflows Using the
Income Statement Format
Revenue
Expenses (excluding depreciation)
Profits before depreciation and taxes
Depreciation
Net profits before taxes
Taxes
Net profits after taxes
Depreciation
Operating cash inflows




over 6 years, the analysis must be performed over the 6-year period to capture
fully the tax effect of its year-6 depreciation. The resulting operating cash inflows
are shown in the final row of Table 8.8 for each machine. The $8,000 year-6 cash
inflow for the proposed machine results solely from the tax benefit of its year-6
depreciation deduction.
322 PART 3 Long-Term Investment Decisions


TABLE 8.8 Calculation of Operating Cash Inflows for Powell Corporation’s
Proposed and Present Machines
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

With proposed machine

Revenuea $2,520,000 $2,520,000 $2,520,000 $2,520,000 $2,520,000 $ 0
Expenses (excl. depr.)b 2,300,000 2,300,000 2,300,000 2,300,000 2,300,000 0
Profits before depr. and taxes $ 220,000 $ 220,000 $ 220,000 $ 220,000 $ 220,000 $ 0
Depreciationc 80,000 128,000 76,000 48,000 48,000 20,000
Net profits before taxes $ 140,000 $ 92,000 $ 144,000 $ 172,000 $ 172,000 $20,000
Taxes (rate 40%) 56,000 36,800 57,600 68,800 68,800 8,000
Net profits after taxes $ 84,000 $ 55,200 $ 86,400 $ 103,200 $ 103,200 $12,000
Depreciationc 80,000 128,000 76,000 48,000 48,000 20,000
Operating cash inflows $ 164,000 $ 183,200 $ 162,400 $ 151,200 $ 151,200 $ 8,000

With present machine

Revenuea $2,200,000 $2,300,000 $2,400,000 $2,400,000 $2,250,000 $ 0
Expenses (excl. depr.)b 1,990,000 2,110,000 2,230,000 2,250,000 2,120,000 0
Profits before depr. and taxes $ 210,000 $ 190,000 $ 170,000 $ 150,000 $ 130,000 $ 0
Depreciationc 28,800 28,800 12,000 0 0 0
Net profits before taxes $ 181,200 $ 161,200 $ 158,000 $ 150,000 $ 130,000 $ 0
Taxes (rate 40%) 72,480 64,480 63,200 60,000 52,000 0
Net profits after taxes $ 108,720 $ 96,720 $ 94,800 $ 90,000 $ 78,000 $ 0
Depreciationc 28,800 28,800 12,000 0 0 0
Operating cash inflows $ 137,520 $ 125,520 $ 106,800 $ 90,000 $ 78,000 $ 0
aFrom column 1 of Table 8.5.
bFrom column 2 of Table 8.5.
cFrom column 3 of Table 8.6.




Interpreting the Term Incremental
The final step in estimating the operating cash inflows for a proposed project is to
calculate the incremental (relevant) cash inflows. Incremental operating cash
inflows are needed, because our concern is only with the change in operating cash
inflows that result from the proposed project.

Table 8.9 demonstrates the calculation of Powell Corporation’s incremental (rele-
EXAMPLE
vant) operating cash inflows for each year. The estimates of operating cash
inflows developed in Table 8.8 are given in columns 1 and 2. Column 2 values
represent the amount of operating cash inflows that Powell Corporation will
receive if it does not replace the present machine. If the proposed machine replaces
the present machine, the firm’s operating cash inflows for each year will be those
shown in column 1. Subtracting the present machine’s operating cash inflows
from the proposed machine’s operating cash inflows, we get the incremental oper-
323
CHAPTER 8 Capital Budgeting Cash Flows


TABLE 8.9 Incremental (Relevant) Operating Cash
Inflows for Powell Corporation

Operating cash inflows

Incremental (relevant)
Proposed machinea Present machinea [(1) (2)]
Year (1) (2) (3)

1 $164,000 $137,520 $26,480
2 183,200 125,520 57,680
3 162,400 106,800 55,600
4 151,200 90,000 61,200
5 151,200 78,000 73,200
6 8,000 0 8,000
aFrom final row for respective machine in Table 8.8.




ating cash inflows for each year, shown in column 3. These cash flows represent
the amounts by which each respective year’s cash inflows will increase as a result
of the replacement. For example, in year 1, Powell Corporation’s cash inflows
would increase by $26,480 if the proposed project were undertaken. Clearly,
these are the relevant inflows to be considered when evaluating the benefits of
making a capital expenditure for the proposed machine.


Review Questions

8–13 How does depreciation enter into the calculation of operating cash
inflows?
8–14 How are the incremental (relevant) operating cash inflows that are associ-
ated with a replacement decision calculated?



Finding the Terminal Cash Flow
LG6

Terminal cash flow is the cash flow resulting from termination and liquidation of
a project at the end of its economic life. It represents the after-tax cash flow,
exclusive of operating cash inflows, that occurs in the final year of the project.
When it applies, this flow can significantly affect the capital expenditure decision.
Terminal cash flow can be calculated for replacement projects by using the basic
format presented in Table 8.10.


Proceeds from Sale of Assets
The proceeds from sale of the new and the old asset, often called “salvage value,”
represent the amount net of any removal or cleanup costs expected upon termina-
tion of the project. For replacement projects, proceeds from both the new asset
324 PART 3 Long-Term Investment Decisions


TABLE 8.10 The Basic Format
for Determining
Terminal Cash Flow

After-tax proceeds from sale of new asset
Proceeds from sale of new asset
Tax on sale of new asset
After-tax proceeds from sale of old asset
Proceeds from sale of old asset
Tax on sale of old asset
Change in net working capital
Terminal cash flow



and the old asset must be considered. For expansion and renewal types of capital
expenditures, the proceeds from the old asset are zero. Of course, it is not
unusual for the value of an asset to be zero at the termination of a project.


Taxes on Sale of Assets
Earlier we calculated the tax on sale of old asset (as part of finding the initial
investment). Similarly, taxes must be considered on the terminal sale of both the
new and the old asset for replacement projects and on only the new asset in other
cases. The tax calculations apply whenever an asset is sold for a value different
from its book value. If the net proceeds from the sale are expected to exceed book
value, a tax payment shown as an outflow (deduction from sale proceeds) will
occur. When the net proceeds from the sale are less than book value, a tax rebate
shown as a cash inflow (addition to sale proceeds) will result. For assets sold to
net exactly book value, no taxes will be due.


Change in Net Working Capital
When we calculated the initial investment, we took into account any change in net
working capital that is attributable to the new asset. Now, when we calculate the
terminal cash flow, the change in net working capital represents the reversion of
any initial net working capital investment. Most often, this will show up as a cash
inflow due to the reduction in net working capital; with termination of the project,
the need for the increased net working capital investment is assumed to end.
Because the net working capital investment is in no way consumed, the amount
recovered at termination will equal the amount shown in the calculation of the ini-
tial investment. Tax considerations are not involved.

Calculating the terminal cash flow involves the same procedures as those
used to find the initial investment. In the following example, the terminal cash
flow is calculated for a replacement decision.

Continuing with the Powell Corporation example, assume that the firm expects
EXAMPLE
to be able to liquidate the new machine at the end of its 5-year usable life to net
$50,000 after paying removal and cleanup costs. The old machine can be liqui-
325
CHAPTER 8 Capital Budgeting Cash Flows


dated at the end of the 5 years to net $0 because it will then be completely obso-
lete. The firm expects to recover its $17,000 net working capital investment upon
termination of the project. Both ordinary income and capital gains are taxed at a
rate of 40%.
From the analysis of the operating cash inflows presented earlier, we can see
that the proposed (new) machine will have a book value of $20,000 (equal to the
year-6 depreciation) at the end of 5 years. The present (old) machine will be fully
depreciated and therefore have a book value of zero at the end of the 5 years.
Because the sale price of $50,000 for the proposed (new) machine is below its ini-
tial installed cost of $400,000 but greater than its book value of $20,000, taxes
will have to be paid only on the recaptured depreciation of $30,000 ($50,000 sale
proceeds $20,000 book value). Applying the ordinary tax rate of 40% to this
$30,000 results in a tax of $12,000 (0.40 $30,000) on the sale of the proposed
machine. Its after-tax sale proceeds would therefore equal $38,000 ($50,000 sale
proceeds $12,000 taxes). Because the present machine would net $0 at termi-
nation and its book value would be $0, no tax would be due on its sale. Its after-
tax sale proceeds would therefore equal $0. Substituting the appropriate values
into the format in Table 8.10 results in the terminal cash inflow of $55,000.
After-tax proceeds from sale of proposed machine
Proceeds from sale of proposed machine $50,000
Tax on sale of proposed machine 12,000
Total after-tax proceeds—proposed $38,000
After-tax proceeds from sale of present machine
Proceeds from sale of present machine $ 0
Tax on sale of present machine 0
Total after-tax proceeds—present 0
Change in net working capital 17,000
Terminal cash flow $55,000


Review Question

8–15 Explain how the terminal cash flow is calculated for replacement projects.



Summarizing the Relevant Cash Flows
LG4 LG5 LG6

The initial investment, operating cash inflows, and terminal cash flow together
represent a project’s relevant cash flows. These cash flows can be viewed as the
incremental after-tax cash flows attributable to the proposed project. They repre-
sent, in a cash flow sense, how much better or worse off the firm will be if it
chooses to implement the proposal.

The relevant cash flows for Powell Corporation’s proposed replacement expendi-
EXAMPLE
ture can now be shown graphically, on a time line. Note that because the new
asset is assumed to be sold at the end of its 5-year usable life, the year-6 incremen-
tal operating cash inflow calculated in Table 8.9 has no relevance; the terminal
326 PART 3 Long-Term Investment Decisions


cash flow effectively replaces this value in the analysis. As the following time line
shows, the relevant cash flows follow a conventional cash flow pattern.

$ 55,000 Terminal Cash Flow
Time line for Powell
73,200 Operating Cash Inflow
Corporation’s relevant
$26,480 $57,680 $55,600 $61,200 $128,200 Total Cash Flow
cash flows with the
proposed machine

0
1 2 3 4 5



$221,160
End of Year

Techniques for analyzing conventional cash flow patterns to determine
whether to undertake a proposed capital investment are discussed in Chapter 9.


Review Question

8–16 Diagram and describe the three components of the relevant cash flows for
a capital budgeting project.




SUMMARY
FOCUS ON VALUE
A key responsibility of financial managers is to review and analyze proposed investment
decisions in order to make sure that only those that contribute positively to the value of the
firm are undertaken. Utilizing a variety of tools and techniques, financial managers estimate
the cash flows that a proposed investment will generate and then apply appropriate decision
techniques to assess the investment’s impact on the firm’s value. The most difficult and
important aspect of this capital budgeting process is developing good estimates of the rele-
vant cash flows.
The relevant cash flows are the incremental after-tax cash flows resulting from a pro-
posed investment. These estimates represent the cash flow benefits that are likely to accrue

ńňđ. 1
(âńĺăî 2)

ŃÎÄĹĐĆŔÍČĹ

>>