Capital Budgeting and Estimating Cash

Flows
When a business makes a capital investment, it spends money now, hoping to get
benefits in the future, usually after more than a year.

These investments can be for things like buying equipment, buildings, or land, or
starting new products, delivery systems, or research projects.

In short, the business's future success and profits depend on the decisions it makes
today.
 An investment proposal should be judged on whether it gives a return that meets or
exceeds what investors expect.

 To make things simpler in this chapter, we will assume that the required return is the
same for all investment projects.

 This means that selecting any investment project does not change the company's
business risk, as seen by those providing financing.

 However, different projects have different levels of risk. Choosing a project can
affect the company’s risk, which may change the return investors expect.
Capital budgeting : The process of finding, studying, and choosing investment projects that
are expected to make money (cash flows) for more than one year.

Capital budgeting includes:

1. Creating investment project ideas that align with the company's goals.
2. Estimating the extra money the company will make from these projects after taxes.
3. Analyzing the cash flow of each project.
4. Choosing projects that will create the most value for the company.
5. Continuously reviewing ongoing projects and checking completed projects to see if they
were successful.
Generating Investment Project
Proposals
Investment project proposals can come from many different sources. For easier
analysis, these projects are often grouped into five categories:

 New products or expansion of existing products : Creating

new products or improving existing ones to grow the business.

 Replacement of equipment or buildings : Updating or

replacing outdated machinery, equipment, or buildings to
improve efficiency.
Research and development : Investing in new ideas, technologies, or innovations to
create better products or services.

Exploration : Looking for new resources, markets, or business opportunities, such as

natural resources or expanding into new regions.

Other (for example, safety-related or pollution-control devices) : Projects focused

on improving safety or reducing environmental impact, like installing safety equipment
or pollution control systems.
New product ideas usually come from the marketing department, while equipment
changes are typically suggested by the production team.

It's important to have clear processes for handling investment requests.

All proposals should match the company's strategy to avoid wasting time on ideas that
don't fit.

Example : McDonald's wouldn't sell cigarettes in its restaurants.

Most companies review proposals at several levels of authority. For a proposal from the production area, the
approval process might go through :

 Section Chiefs: Check if the proposal makes sense for their department.

 Plant Managers: See if it fits with production goals.

 Vice President for Operations: Looks at how it fits with the company's bigger plans.

 Capital Expenditures Committee with the Financial Manager: Reviews the cost and whether it’s a good
financial decision.

 President: Decides if it fits with the company’s long-term goals and strategy

 Board of Directors: Gives the final "yes" to make sure it’s good for the company in the long run.
The approval process depends on the cost of the proposal—higher costs usually
require more levels of review.

Plant managers can approve smaller projects, but larger ones need approval from higher
levels.

Each company has its own way of reviewing proposals, and the best process depends on
the specific situation.

However, companies are becoming more advanced in how they handle capital budgeting.
 Estimating Project “After-Tax Incremental Operating
Cash Flows”

In capital budgeting, it's very important to estimate future cash flows

accurately.

The results of our analysis depend on how well we predict these cash flows.

Cash is what really matters for decision-making in a company, not just profits.

That's why we focus on the cash that a project will generate, rather than just
the income it will produce.
When a company invests money today, it expects to get more cash back in the future.

This extra cash can be used to reinvest in the business or paid out as dividends to
shareholders.

So, in capital budgeting, the goal is to make sure the project brings in cash.

Using a spreadsheet is really helpful for planning cash flows. It allows us to quickly
change assumptions (like costs or expected returns) and see how those changes affect
the cash flow predictions.

This makes it easier to adjust and make better decisions.

For each investment proposal, we focus on :

Operating cash flows, which are the cash flows from the project itself.

Financing cash flows like interest, loan payments, and dividends are not included in this
analysis.

However, we still need to consider how much it costs to get the money for the investment.

We do this by using a discount rate (or hurdle rate) that reflects the return required by
those who provide the capital, like investors or Lenders.
Cash flows should be calculated after taxes, including the initial investment and discount rate.
All future cash flows must also reflect after-tax amounts.

For cash flow analysis we look only at the difference in cash flows with and without the
project.

For example, if a new product competes with existing ones, we should consider how sales of
the new product might reduce sales of the old products (cannibalization).

We also need to consider any loss in market share if we don’t make the
new investment.

The focus is on the extra cash the project brings in, not total sales. What matters is how the
project changes things—whether it makes more money or causes a loss.
We should ignore sunk costs (Past costs that can't be recovered shouldn't influence
current or future decisions) because they can't be recovered. What matters are the
additional costs and benefits the project will bring.

Some costs don’t involve actual money spent but still matter.

Example 1 : If we use plant space for the project that could be used for something else,
we need to consider the opportunity cost (the value of what we give up).

Example 2 : If we have an unused building for the project, and it could be sold for
$300,000, we should treat that as if it’s a cash outflow (even though we’re not actually
spending the money).

So, when calculating cash flows, we need to include any relevant opportunity costs.
When a capital investment includes current assets (like cash or inventory), they are
part of the investment, not a separate decision. Extra working capital is a cash outflow
at the start and a cash inflow when the project ends.

Inflation must be included in cash flow estimates, as it affects both income (prices)
and expenses (wages, materials).
 Tax Considerations
Method of Depreciation : is how a company divides the cost of the asset over several
years instead of counting the entire cost all at once.

While depreciation is not a cash expense, it helps improve cash flow by reducing tax
payments.

Example : If a company buys a machine for $10,000, it might spread that cost over 5
years. So each year, the company "counts" $2,000 as an expense, even though the
machine is still in use.

This helps lower the company's taxes, because the more expenses they have, the less
taxable income they report, and thus, they pay less in taxes.
There are several methods companies can use to depreciate their assets. The two main types are
straight-line depreciation and accelerated depreciation.

 Straight-line depreciation spreads the cost of an asset in equal amounts over its useful life.

For example: If an asset costs $10,000 and lasts 5 years, it would be depreciated by $2,000 each
year.

 Accelerated depreciation means a company can deduct a larger portion of the cost of an asset
in the first few years of using it, rather than spreading the cost evenly over time.

For example: The company might deduct more than $2,000 in the first year—say $3,000—and
then smaller amounts in later years. This way, the company gets a bigger tax deduction early on.
The Tax Reform Act of 1986 introduced MACRS (Modified Accelerated Cost
Recovery System), which allows businesses to depreciate assets more quickly, reducing
taxes in the early years.

Under MACRS, assets like machinery, equipment, and real estate are placed into one of
eight classes. Each class determines how long the asset can be depreciated for tax
purposes.

Can MACRS depreciation be utilized by US companies on equipment used outside the

United States ?

No. Generally, MACRS depreciation is not allowed for equipment that is used pre
dominantly outside the United States during the taxable year. For such equipment, the
Alternative Depreciation System (ADS) is required. ADS is a straight-line method of
depreciation (determined without regard to estimated future salvage value).
The depreciable basis is the cost of the asset that can be used to figure out how much
you can deduct on our taxes each year, spread over the asset's useful life.

The cost of the asset, including any other capitalized 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.

Such as shipping and installation – that are incurred to prepare the asset for its intended
use, constitutes the asset’s depreciable basis under MACRS.

Under MACRS the asset’s depreciable basis is not reduced by the estimated salvage
value (what it might be worth at the end of its life) of the asset.
 Sale or Disposal of a
Depreciable Asset.
 If a business sells a depreciable asset for more than its depreciated value (the value
after depreciation), any amount above that value but below the original cost
(depreciable basis) is called recaptured depreciation.

 This extra amount is taxed as ordinary income. It basically cancels out some of the
earlier tax savings from depreciation.

If the asset sells for more than its original cost (which is rare), the extra amount is taxed
at the capital gains tax rate. Right now, the capital gains rate is the same as the ordinary
income tax rate, which can be as high as 35%.
 If the asset is sold for less than its tax value (the amount it’s worth for tax
purposes), the difference between the selling price and the tax value is a loss.

 This loss can be deducted from the business’s regular income, which means the
business can pay less in taxes.

 Essentially, the loss helps reduce taxable income, giving the business tax savings.
The tax savings are calculated by multiplying the loss by the business’s tax rate (for
example, 40%).

 So, even though the business has a paper loss (on paper, the asset lost value), it gets
real savings on its taxes.