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MAhmed 3269 18189 2 Lecture Capital Budgeting and Estimating

Here are the key steps to calculate the incremental cash flows from replacing the old mold with the new mold: 1) Initial cash outflow = Cost of new mold ($18,500) + Installation costs ($1,500) - Proceeds from sale of old mold ($2,000) = $18,000 2) Interim cash flows (years 1-4) = Annual cash savings from labor/maintenance ($7,100) 3) Terminal year cash flow (year 4) = No salvage value or other cash flows 4) Incremental cash flows = Initial cash outflow of $18,000 plus net cash flows of $7,100 in each of the first 4 years.

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68 views12 pages

MAhmed 3269 18189 2 Lecture Capital Budgeting and Estimating

Here are the key steps to calculate the incremental cash flows from replacing the old mold with the new mold: 1) Initial cash outflow = Cost of new mold ($18,500) + Installation costs ($1,500) - Proceeds from sale of old mold ($2,000) = $18,000 2) Interim cash flows (years 1-4) = Annual cash savings from labor/maintenance ($7,100) 3) Terminal year cash flow (year 4) = No salvage value or other cash flows 4) Incremental cash flows = Initial cash outflow of $18,000 plus net cash flows of $7,100 in each of the first 4 years.

Uploaded by

Sadia Abid
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Capital budgeting and Estimating

Cash flows
Capital budgeting
The process of identifying, analyzing and selecting investment projects whose
returns (cash flows) are expected to extend beyond one year.

What does Capital budgeting involves?


 Generating investment proposals consistent with the firm’s strategic
objectives
 Estimating after-tax operating cash flows for investment projects
 Evaluating project incremental cash flows
 Selecting projects based on a value-maximizing acceptance criterion
 Re-evaluating implemented projects and performing post-audits for
for completed projects.
BASIC CHARACTERISTICS OF RELEVANT PROJECT CASH FLOWS

Cash flows (not accounting income)


Operating (not financing) cash flows
After-tax cash flows
Incremental cash flows

BASIC PRINCIPLES THAT MUST BE ADHERED TO IN ESTIMATING


“AFTER-TAX INCREMENTAL OPERATING CASH FLOWS”

Sunk costs
Opportunity costs
Changes in Working Capital (project-driven)
Effects of Inflation
Calculating the Incremental Cash flows
1) Initial Cash outflow (the initial net cash investment)
2) Interim incremental net cash flows (intermediate cash flows
but not final period’s cash flow)
3) Terminal-year incremental net cash flow (Net cash flows
at project termination)
Basic Format for determining Initial Cash outflow
Cost of new asset(s)
+ Capitalized Expenditures

+(-) Increased (decreased)level of working capital

- Net proceeds from Sale of old asset(s) if investment is


replacement decision

+(-) Taxes (tax savings) due to the sale of old asset if the
investment is
Replacement decision

= Initial Cash outflow


Basic Format for determining Interim
Incremental Net Cash outflow
Net increase (decrease) in Operating revenues
- (+) Net increase (decrease) in operating expenses excluding Dep.

- (+) Increase (decrease) in tax depreciation charges

= Net change in Income before taxes

- (+) Net Increase (decrease) in taxes

= Net changes in income after taxes

+ (-) Net increase (decrease) in tax depreciation charges

= Incremental net cash flow for the period


Basic Format for determining terminal year
Incremental Net Cash outflow
Net increase (decrease) in Operating revenues
- (+) Net increase (decrease) in operating expenses excluding Dep.

- (+) Increase (decrease) in tax depreciation charges

= Net change in Income before taxes

- (+) Net Increase (decrease) in taxes

= Net change in income after taxes

+ (-) Net increase (decrease) in tax depreciation charges

= Incremental net cash flow for the terminal year before


project windup considerations

+ (-) Final salvage value (disposal costs) of new assets

- (+) Taxes (tax savings) due to sales/disposal of new asset(s)

+(-) Decreased (increased) level of net working capital

= Terminal year incremental net cash flow


Example of Asset Expansion:

The Faversham Fish farm is considering the introduction of a new fish-flaking facility.
To launch the facility, it will need to spend $90,000 for special equipment. The
equipment has a useful life of four years and is in the three-year property class fro
tax purposes. Shipping and installation expenditures equal $10,000 and the
machinery has an expected final salvage value, four years from now, of $16,500. The
machinery is to be housed in an abandoned warehouse next to the main processing
plant. The old warehouse has no alternative economic use. No additional ‘net’
working capital is needed. The marketing department envisions that use of new
facility will generate additional net operating revenue cash flows, before
consideration of depreciation and taxes as follows:
End of Year
1 2 3 4
Net cash $35,167 $36,250 $55,725 $32,258
flows

Assuming that the marginal tax rate equals 40 percent, estimate the project’s
relevant incremental cash flows.
Example of Asset Replacement
We are considering the purchase of a new automotive-glass mold to replace an old
mold and that we need to obtain cash-flow information to evaluate the attractiveness
of this project. The purchase price of the new mold is $18,500, and it will require an
additional $1,500 to install, bringing the total cost to $20,000. The old mold, which has
a remaining useful life of four years, can be sold for its depreciated (tax) book value of
2,000. The old mold have no salvage value of held to the end of its useful life. Notice
that , as salvage value equals tax book value, taxes due to the sale of the old asset are
zero.
The new machine should cut labor and maintenance costs and produce other cash
savings totaling $7,100 a year before taxes for each of the next four years, after which
it will probably not provide any savings nor have a salvage value. Suppose that the new
mold we are considering falls into the three-year property category for MACRS
depreciation. Moreover, assume the following in regards to the old mold:
1. The original depreciable basis was $9,000.
2. The mold fell into the three-year property class.
3. The remaining depreciable life is two years.

Required:
Calculate the expected incremental net cash flows from the project.

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