Topic 8

Capital budgeting II –
Cash flow and capital
budgeting
Chapter 10
Department of Finance
Deakin Business School, T3 2017
1
Recap –Topic 7
• What is capital budgeting:
• Analysing potential projects with large expenditures for
long-term decision to increase firm value and
shareholders’ wealth
• The ideal characteristics of a capital budgeting
technique
• 6 capital budgeting techniques payback period,
discounted payback period, accounting rate of return,
net present value, internal rate of return, profitability
index
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• The advantages and disadvantages of this techniques
Recap
•

Average profits after taxes

ARR 
Average investment
Recap
• NPV method
• PV inflows – Cost, accept project if NPV > 0.
• Choose project with the highest NPVs between mutually
exclusive projects, and adds most value.
n

4
CFt
NPV  CF0  
1  r 
t
t 1

• Consider time value of money, focus on CFs, account for risk of

CFs, but not intuitive, not very managerial flexible
• IRR method
• IRR > WACC (cost of capital), accept the project
• Intuitive, use CFs, and consider time value of money
n
• Changing rate and sign of CFs probs CFt
• Math prob, scale prob, and timing prob
CF0  
t 1 1  IRR 
t
Recap
• PI method
• Accept project when PI > 1, equal to NPV > 0
• Like IRR, PI suffers from the scale problem
n
CFt
 1  r  t

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t 1
PI 
CF0
• If the results are conflict between capital budgeting tools,
always choose the project using NPV method
Method Criterion Result Decision
NPV Positive $10.10 Accept
Payback 3 Years 4 Years Reject
Discounted Payback 5 Years 6 Years Reject
Return on Book Value 12% 18.71% Accept
IRR 10% 12.40% Accept
Profitability Index 1 1.067 Accept
Capital Budgeting
• What is capital budgeting
• Analysis of potential projects.
• Long-term decisions; involve large expenditures.
• Very important to firm’s future.
• Steps in capital budgeting
• Estimate cash flows (inflows & outflows).
• Assess risk of cash flows, and determine r (WACC) for project.
• Evaluate cash flows.
• Independent vs mutually exclusive projects
• independent, if the cash flows of one are unaffected by
the acceptance of the other.
• mutually exclusive, if the cash flows of one can be
adversely impacted by the acceptance of the other.
Capital budgeting process
1. Estimation of Cash Flows
• If we invest in this project, how do cash flows differ?
• Incremental, after tax (money available to investors).
2. Evaluation of Cash Flows
• How risky are these cash flows?
• What is the appropriate discount rate?
3. Project Acceptance/Rejection
• Positive net present value
• Be aware of mutually exclusive projects with different lives.
4. Monitoring and Post-auditing
• Were estimations accurate?
• How can we improve in the future?
Learning outcomes
After studying this topic, you will be able to
• Identify the types of cash flows in the capital
budgeting process; incremental cash flows
• Discuss depreciation, fixed asset expenditures and
working capital
• Discuss sunk costs, opportunity costs and
cannibalization
• Describe capital rationing decision and the effect of
human element on the capital budgeting process

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10.1 Types of cash flow
• Capital budgeting is concerned with cash flow,
not accounting profit.
• The timing and magnitude of cash flows and
accounting profits can differ dramatically
• To evaluate a capital investment, we must know:
• the incremental cash outflows of the
investment, and the incremental cash inflows
of the investment.
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 Focusing on incremental cash flows
• The cash flow that should be included in a capital
budgeting analysis is incremental cash flow.
• Incremental CF = CF with a project – CF without a project
• Cash flows that will only occur if the project is accepted.

• Ask yourself, “Will this CF occur ONLY if a project is

accepted?”
• “Yes”, then include this CF in the analysis
• “No”, then exclude this CF from the analysis
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Determination of project cash flows
• Incremental Cash Flows: Differences in cash flow to the firm with and
without the investment.

• Three major categories of cash flows:

1. Initial cash flows

• Purchase of equipment and land (investment) etc.
• Hiring/firing of staff
• Initial working capital
2. Annual (recurring) cash flows.
• Income and Expenses
• Depreciation tax shields or tax savings
• Annual working capital
3. Terminal cash flows
• Salvage value of machines/land (after tax)
• Regulatory abandonment expenses
• Recovery of working capital
 Sales
- Cost of goods sold
Gross profit
- Operating costs (Selling & Admin expenses)
- Depreciation expenses
Earnings before interest & taxes (EBIT)
- Taxes
Earnings after taxes (Net Income)
+ Depreciation expenses
Operating cash flow (OCF)
- Capital spending
- Change in NWC (Incremental CF)
Net cash flow

Operating Change in
Cash
= - Capital - Net Working
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Flow Cash Flow Spending Capital
Ignoring financing costs and
Considering taxes
• Financing costs should be excluded when
evaluating a project’s cash flows.
• Both interest expenses from debt financing and
dividend payments to equity investors should
be excluded.
• Financing costs are captured in the process of
discounting future cash flows.
• Only after-tax cash flows are relevant as only such
cash flows can be distributed to investors.
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Adjusting for non-cash expenses
• Non-cash expenses such as depreciation and amortisation
• Accountants charge depreciation to spread a fixed asset’s
costs over time to match its benefits.
• Capital budgeting analysis focuses on cash inflows and
outflows when they occur.
• Non-cash expenses affect cash flow through their impact
on taxes:
• Compute after-tax net income and add depreciation back;
or
• Ignore depreciation expense but add back its tax savings.
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 1st method 2nd method
Sales Sales
- Cost of goods sold - Cost of goods sold
Gross profit Gross profit
- Operating costs - Operating costs
- Depreciation expenses
Earnings before interest & Earnings before interest &
taxes (EBIT) taxes (EBIT)
- Taxes - Taxes
Earnings after taxes (NI) Earnings after taxes (NI)
+ Depreciation expenses + Depreciation tax shield
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Operating cash flow Operating cash flow
(OCF) (OCF)
Example: Non-cash expenses
• A company spends $30,000 in cash to purchase a
fixed asset that will be fully depreciated on a straight-
line basis over three years.
• The Company pays taxes at 30% marginal rate.

Costs $1/unit
Company will produce 10 000
units/year
Sells for $3/unit

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Example: Non-cash expenses
Sales: 10,000 x $3 = $30,000
Cost of goods: 10,000 x $1 = $10,000
Depreciation = $30,000/3 = $10,000
Taxes = $10,000 x 30% = $3,000

Dep tax saving  17
= Dep expenses x Marginal tax rate
= $10,000 x 30% = $3,000
10.1 Depreciation
• Many countries allow one depreciation method for tax
purposes and a different one for reporting purposes.

• However, as depreciation only affects cash flow

Finance
through taxes, capital budgeting should consider that
depreciation method which a company uses for tax
purposes when determining project cash flows.

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 Fixed asset
• Initial cash flows
• Cash outflow to acquire/install fixed assets
• Cash inflow from selling old equipment
• Cash inflow (outflow) if selling old equipment below
(above) tax basis generates tax savings (liability)

New equipment costs $10 million,

An example … $0.5 million to install
Tax rate = 40%
Old equipment fully depreciated, sold
for $1 million

Initial investment: outflow of $10.5 million and 19

after-tax inflow of $0.60 million from selling the old equipment
(Capital gain: 1-0=1m, tax 1*0.4=0.4m, Sale cash inflow 1-0.4=0.6m)
Tax on sale of Building & Equipment

Tax on Sale: Building

Salvage Value 7,500

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Book Value 10,908
Profit/Loss -3,408
Tax 1,363

Tax on Sale: Equipment

Salvage Value 2,000
Book Value 1,360
Profit/Loss 640
Tax -256
After-tax Cash Flow from
Asset Sale
• If the actual sale price is different from the book
value of the asset, then there is tax effect
• Book value = initial cost – accumulated depreciation
(if the asset is fully depreciated, then the book value

Finance
= 0)

• Tax on capital gain or loss = Tax rate *(sale price –

book value)
• After-tax cash flow from asset sale = sale price –
Tax rate*(sale price – book value)
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Net working capital
• Many capital investments require additions to
working capital.
• Net working capital (NWC)
= current assets – current liabilities.
• Increase in NWC is a cash outflow.
• eg, purchase inventory, cash outflow,
Inventory increase, current assets increase, NWC increase
• Decrease in NWC is a cash inflow.
*Implicit assumption in this unit: NWC will be 
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recovered at the end of the project, see 
example and workshop practices
10.2 Incremental cash flows

• Sunk costs is a cost that has already been paid

and is therefore not recoverable
• Example of sunk costs: Any expense that cannot
be avoided irrespective of whether the project
goes ahead or not e.g. legal/technical consultant
fees.
• Sunk costs are irrelevant and therefore should be
ignored when determining cash flows.
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• There is no crying over spilled milk!
Opportunity costs & “Cannibalization”
• Opportunity costs are returns from alternative
investment opportunities, that are necessarily
forgone when one particular investment is
undertaken.

• “Cannibalisation” refers to the loss of revenues

from an existing product when a new product
is introduced. “Cannibalisation” results from a
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‘substitution’ effect.
Cannibalization
“Cannibalization”: ‘substitution’ or ‘Complement’ effect.
• The effects on the other projects’ CFs are
“externalities”.
• If the new product line would decrease sales of the
firm’s other products by $50,000 per year, this is called
cannibalization.
• Net CF loss per year on other lines would be a cost to
this project.
• iPhone sales are Cannibalizing iPads,
• iPhone sales are Cannibalizing iPods
• iPhone sales are Cannibalizing Mac computers
• Externalities will be positive if new projects are
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complements to existing assets, negative if substitutes.
• Computer equipment sales, copying machine equipments
Example: NPV analysis
• Suppose we can sell 50,000 units per year at the price
of $4 per unit. Variable cost is $2.5/unit.
• Fixed cost is $12,000 per year (e.g. rent,
administrative cost, etc.)
• We will need to invest $90,000 in equipment which is
fully depreciated over the three-year life of the project.
• In addition, the project requires an initial $20,000
investment in net working capital. The tax rate is 34%.
We require a 20% return on new product.
• Should we accept the project? 26
Implicit assumption: NWC will be recovered at 
the end of the project
1. Suppose we can sell 50,000 units per year, $4 per unit. = 50,000x$4=$200,000
2. Variable cost is $2.5/unit. = 50,000x$2.5=$125,000 
Example: NPV analysis
3. Fixed cost is $12,000 per year 
4. We will need to invest $90,000 in equipment which is fully depreciated over 
the three‐year life of the project. Depreciation = $90,000/3 = $30,000
• Income Statement

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1. We will need to invest $90,000 in equipment
2. In addition, the project requires an initial $20,000 investment in 
net working capital. 

• Projected cash flows

Year 0 1 2 3
OCF $51,780 $51,780 $51,780
NCS (90,000)
Change in (20,000) 20,000
NWC

CFA (110,000) $51,780 $51,780 $71,780

NPV 10,648 Accept
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Example: NPV analysis with
salvage value
• A three-year expansion project.
• An initial fixed asset investment of $2.1 million.
• Straight-line depreciation to zero.
• The fixed asset can be sold for of $325,000 at the end of
the project (This is also known as ‘Salvage Value’)
• The project is to generate $1,900,000 in annual sales,
with costs of $850,000.
• Initial investment in NWC is $275,000.
• The tax rate is 35 percent.
• The required return on the project is 15%.
• Should the project be undertaken? 29
Implicit assumption: NWC will be recovered at 
the end of the project
MPF753 Week 6
1. & 2. The project is to generate $1,900,000 in annual sales, with costs of 
$850,000
3. A three‐year expansion project. An initial fixed asset investment of $2.1 
million. Straight‐line depreciation to zero.

Income Statement

Sales 1,900,000
- Costs (850,000)
Gross profit 1,050,000
- Depreciation (2.1m/3) (700,000)
EBIT 350,000
- Tax (35%) (122,500)
NI 227,500
OCF = NI+Dep 927,500 30
MPF753 Week 6
4. The fixed asset can be sold for of $325,000 at the end of the project (This is
also known as ‘Salvage Value’)

Calculate Cash Flows – A

Year 0 1 2 3
OCF 927,500 927,500 927,500
NCS (2,100,000)
Change in NWC (275,000) 275,000
Salvage 325,000
- Tax (35%) (113,750)
CFA (2375000) 927,500 927,500 1,413,750

Calculate NPV
927,500 927,500 1,413,750 31
NPV  2,375,000     62,409
1  0.15 (1  0.15) (1  0.15)
2 3
MPF753 Week 6

Calculate Cash Flows – B

After-tax salvage
= salvage value – T(salvage – book value)
= 325,000 - 0.35(325,000 - 0) = 211,250

Year 0 1 2 3
OCF 927,500 927,500 927,500
Less NCS (2,100,000) 211,250
Change in NWC (275,000) 275,000
CFA (2375000) 927,500 927,500 1,413,750

Calculate NPV
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927,500 927,500 1,413,750
NPV  2,375,000     62,409
1  0.15 (1  0.15) (1  0.15)
2 3
10.4 Capital rationing
• Can a company accept all investment projects with
positive NPV?
• Reasons why a company would not accept all
projects:
• Limited availability of skilled personnel to be
involved with all the projects.
• Financing may not be available for all projects.
Companies are reluctant to issue new shares to
finance new projects because of the negative signal
this action may convey to the market. Banks may
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set credit ceilings for companies.
10.4 Capital rationing
• Capital rationing: Project combination that
maximizes shareholder wealth subject to
funding constraints.
1. Rank the projects using the Profitability Index (PI).
2. Select the investment with the highest PI.
3. If funds are still available, select the second-highest
PI, and so on, until the capital is exhausted.
4. The steps above ensure that managers select the
combination of projects with the highest NPV. 34
Example: Project Selection with Resource Constraints

• Consider three possible projects with a $100 million

budget constraint
• Possible Projects for a $100 Million Budget

• PI: Accept Projects II & III (Total NPV = 130)

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• NPV: Accept Project I with higher NPV (Total NPV = 110)
Source: Berk, J. and DeMarzo, P. (2011), Corporate Finance, 2nd Edition, Pearson Education Ltd.
 10.5 The human face of capital
budgeting
• Managers must be aware of optimistic bias in the
assumptions made by project supporters.
• Companies should have control measures in place
to remove bias:
• Investment analysis should be done by a group
independent of the individual or group proposing the project.
• Project analysts must have a sense of what is reasonable
when forecasting a project’s profit margin and its growth
potential.
• Story-telling: the best analysts not only provide
numbers to highlight a good investment but also can 36
explain why the investment makes sense.
Learning outcomes
After studying this topic, you will be able to
• Identify the types of cash flows in the capital
budgeting process; incremental cash flows
• Discuss depreciation, fixed asset expenditures and

Finance
working capital
• Discuss sunk costs, opportunity costs and
cannibalization
• Describe capital rationing decision and the effect of
human element on the capital budgeting process

37
The following are excluded from the coverage of Chapter 10:

•Terminal value calculation (sections 10-1e, 10-3d, 10-3e)

•Equipment replacement and EAC (section 10-4b)
•Excess capacity (section 10-4c)

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• End of Week 8 lecture

 Read Chapter 10 and revise today’s lecture slides and your

notes
 Remember to do your scheduled Aplia homework
 Prepare Chapter 11 for Week 9

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