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Chapter 10 - Cash Flows and
Other Topics in Capital
Budgeting
2005, Pearson Prentice Hall
Capital Budgeting: The process of planning
for purchases of long-term assets.
For example: Our firm must decide whether
to purchase a new plastic molding machine
for P 127,000.00. How do we decide?
Will the machine be profitable?
Will our firm earn a high rate of return on
the investment?
The relevant project information follows:
The cost of the new machine is P 127,000.00.
Installation will cost P 20,000.00.
P 4,000.00 in net working capital will be needed
at the time of installation.
The project will increase revenues by P 85,000.00
per year, but operating costs will increase by
35%of the revenue increase.
Simplified straight line depreciation is used.
Asset life is 5 years, and the firm is planning to
keep the project for 5 years.
Salvage value at the end of year 5 will be
P 50,000.00.
14%cost of capital; 34%marginal tax rate.
Capital Budgeting Steps
1) Evaluate Cash Flows
Look at all incremental cash flows
occurring as a result of the project.
Initial outlay
Differential Cash Flows over the life
of the project (also referred to as
annual cash flows).
Terminal Cash Flows
Capital Budgeting Steps
1) Evaluate Cash Flows
0 1 2 3 4 5 n 6 . . .
Terminal
Cash flow
Annual Cash Flows
Initial
outlay
2) Evaluate the Risk of the Project
Well get to this in the next chapter.
For now, well assume that the risk of the
project is the same as the risk of the
overall firm.
If we do this, we can use the firms cost of
capital as the discount rate for capital
investment projects.
Capital Budgeting Steps
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Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
time 0?
(Purchase price of the asset)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
time 0?
(127,000) Purchase price of asset
+ (20,000) Shipping and installation
(147,000) Depreciable asset
+ (4,000) Net working capital
+ 0 Proceeds from sale of old asset
(P 151,000) Net initial outlay
Step 1: Evaluate Cash Flows
b) Annual Cash Flows: What
incremental cash flows occur over the
life of the project?
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
For Each Year, Calculate:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
For Years 1 - 5:
P 85,000 Revenue
(29,750) Costs
(29,400) Depreciation
25,850 EBT
(8,789) Taxes
17,061 EAT
29,400 Depreciation reversal
P 46,461 = Annual Cash Flow
For Years 1 - 5:
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Step 1: Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash
flow at the end of the projects life?
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow
Tax Effects of Sale of Asset:
Salvage value = P 50,000.00.
Book value = depreciable asset - total amount
depreciated.
Book value = P 147,000.00 P 147,000.00
= P 0.00.
Capital gain = SV - BV
= P 50,000.00 0.00 = P 50,000.00
Tax payment = P 50,000.00 x .34 = (P 17,000.00).
Step 1: Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash
flow at the end of the projects life?
P 50,000 Salvage value
(17,000) Tax on capital gain
4,000 Recapture of NWC
P 37,000 Terminal Cash Flow
Project NPV:
CF(0) = - P 151,000.00
CF(1 - 4) = P 46,461.00
CF(5) = 46,461 + 37,000 = P 83,461.00
Discount rate = 14%.
NPV = P 27,721.00
We would accept the project.
Capital Rationing
Suppose that you have evaluated five
capital investment projects for your
company.
Suppose that the VP of Finance has
given you a limited capital budget.
How do you decide which projects to
select?
Capital Rationing
You could rank the projects by IRR:
IRR
5%
10%
15%
20%
25%
$
1 2 3 4 5
P X.XX
Our budget is limited
so we accept only
projects 1, 2, and 3.
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Capital Rationing
You could rank the projects by IRR:
IRR
5%
10%
15%
20%
25%
$
1 2 3
Our budget is limited
so we accept only
projects 1, 2, and 3.
P X.XX
Capital Rationing
Ranking projects by IRR is not
always the best way to deal with a
limited capital budget.
Its better to pick the largest NPVs.
Lets try ranking projects by NPV.
Problems with Project Ranking
1) Mutually exclusive projects of unequal size (the
size disparity problem)
The NPV decision may not agree with IRR or PI.
Solution: select the project with the largest NPV.
Size Disparity Example
Project B
year cash flow
0 (30,000)
1 15,000
2 15,000
3 15,000
required return = 12%
IRR = 23.38%
NPV = P 6,027.00
PI = 1.20
Project A
year cash flow
0 (135,000)
1 60,000
2 60,000
3 60,000
required return = 12%
IRR = 15.89%
NPV = P 9,110.00
PI = 1.07
Problems with Project Ranking
2) The time disparity problem with mutually
exclusive projects.
NPV and PI assume cash flows are
reinvested at the required rate of return for
the project.
IRR assumes cash flows are reinvested at
the IRR.
The NPV or PI decision may not agree with
the IRR.
Solution: select the largest NPV.
Time Disparity Example
Project B
year cash flow
0 (46,500)
1 36,500
2 24,000
3 2,400
4 2,400
required return = 12%
IRR = 25.51%
NPV = P 8,455.00
PI = 1.18
Project A
year cash flow
0 (48,000)
1 1,200
2 2,400
3 39,000
4 42,000
required return = 12%
IRR = 18.10%
NPV = P 9,436.00
PI = 1.20
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Mutually Exclusive Investments
with Unequal Lives
Suppose our firm is planning to expand
and we have to select one of two
machines.
They differ in terms of economic life
and capacity.
How do we decide which machine to
select?
The after-tax cash flows are:
Year Machine 1 Machine 2
0 (45,000) (45,000)
1 20,000 12,000
2 20,000 12,000
3 20,000 12,000
4 12,000
5 12,000
6 12,000
Assume a required return of 14%.
Step 1: Calculate NPV
NPV1 = P 1,433.00
NPV2 = P 1,664.00
So, does this mean #2 is better?
No! The two NPVs cant be
compared!
Step 2: Equivalent Annual
Annuity (EAA) method
If we assume that each project will be
replaced an infinite number of times in the
future, we can convert each NPV to an
annuity.
The projects EAAs can be compared to
determine which is the best project!
EAA: Simply annuitize the NPV over the
projects life.
EAA with your calculator:
Simply spread the NPV over the life
of the project
Machine 1: PV = 1433, N = 3, I = 14,
solve: PMT = -617.24.
Machine 2: PV = 1664, N = 6, I = 14,
solve: PMT = -427.91.
EAA1 = P 617.00
EAA2 = P 428.00
This tells us that:
NPV1 = annuity of P 617.00 per year.
NPV2 = annuity of P 428.00 per year.
So, weve reduced a problem with different
time horizons to a couple of annuities.
Decision Rule: Select the highest EAA. We
would choose machine #1.
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Step 3: Convert back to NPV
Assuming infinite replacement, the
EAAs are actually perpetuities. Get the
PV by dividing the EAA by the required
rate of return.
NPV
1
= P 617.00/.14 = P 4,407.00
NPV
2
= P 428.00/.14 = P 3,057.00
This doesnt change the answer, of
course; it just converts EAA to an NPV
that can be compared.



Practice Problems:
Cash Flows & Other Topics
in Capital Budgeting
Project Information:
Cost of equipment = P 400,000.00
Shipping & installation will be P 20,000.00
P 25,000.00 in net working capital required at
setup.
3-year project life, 5-year asset life.
Simplified straight line depreciation.
Revenues will increase by P 220,000.00 per year.
Defects costs will fall by P 10,000.00 per year.
Operating costs will rise by P 30,000.00 per year.
Salvage value after year 3 is P 200,000.00
Cost of capital = 12%, marginal tax rate = 34%.
Problem 1a
Problem 1a
Initial Outlay:
(P 400,000) Cost of asset
+ ( 20,000) Shipping & installation
(420,000) Depreciable asset
+ ( 25,000) Investment in NWC
(P 445,000) Net Initial Outlay
P 220,000 Increased revenue
10,000 Decreased defects
(30,000) Increased operating costs
(84,000) Increased depreciation
116,000 EBT
(39,440) Taxes (34%)
76,560 EAT
84,000 Depreciation reversal
P 160,560 = Annual Cash Flow
For Years 1 - 3: Problem 1a
Terminal Cash Flow:
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow
Problem 1a
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Terminal Cash Flow:
Salvage value = P 200,000.00
Book value = depreciable asset - total
amount depreciated.
Book value = P 168,000.00
Capital gain = SV - BV = P 32,000.00
Tax payment = P 32,000.00 x .34 =
(P 10,880.00).
Problem 1a
Terminal Cash Flow:
P 200,000 Salvage value
(10,880) Tax on capital gain
25,000 Recapture of NWC
P 214,120 Terminal Cash Flow
Problem 1a
Problem 1a Solution
NPV and IRR:
CF(0) = - P 445,000.00
CF(1 ), (2), = P 160,560.00
CF(3 ) = P 160,560.00 + P 214,120.00 =
P 374,680.00
Discount rate = 12%
IRR = 22.1%
NPV = P 93,044.00 Accept the project!
Project Information:
For the same project, suppose we
can only get P 100,000.00 for the
old equipment after year 3, due to
rapidly changing technology.
Calculate the IRR and NPV for the
project.
Is it still acceptable?
Problem 1b
Terminal Cash Flow:
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow
Problem 1b
Terminal Cash Flow:
Salvage value = P 100,000.00
Book value = depreciable asset - total
amount depreciated.
Book value = P 168,000.00
Capital loss = SV - BV = (P 68,000.00)
Tax refund = P 68,000.00 x .34 =
P 23,120.00
Problem 1b
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Terminal Cash Flow:
P 100,000 Salvage value
23,120 Tax on capital gain
25,000 Recapture of NWC
P 148,120 Terminal Cash Flow
Problem 1b
Problem 1b Solution
NPV and IRR:
CF(0) = - P 445,000.00
CF(1), (2) = P 160,560.00
CF(3) = P 160,560.00 + P 148,120.00 =
P 308,680.00
Discount rate = 12%.
IRR = 17.3%.
NPV = P 46,067.00. Accept the project!
Automation Project:
Cost of equipment = P 550,000.00
Shipping & installation will be P 25,000.00
P 15,000.00 in net working capital required at setup.
8-year project life, 5-year asset life.
Simplified straight line depreciation.
Current operating expenses are P 640,000.00 per yr.
New operating expenses will be P 400,000.00 per yr.
Already paid consultant P 25,000.00 for analysis.
Salvage value after year 8 is P 40,000.00
Cost of capital = 14%, marginal tax rate = 34%.
Problem 2
Problem 2
Initial Outlay:
(P 550,000) Cost of new machine
+ (25,000) Shipping & installation
(575,000) Depreciable asset
+ (15,000) NWC investment
(P 590,000) Net Initial Outlay
P 240,000 Cost decrease
(115,000) Depreciation increase
125,000 EBIT
(42,500) Taxes (34%)
82,500 EAT
115,000 Depreciation reversal
P 197,500 = Annual Cash Flow
For Years 1 - 5:
Problem 2
P 240,000 Cost decrease
( 0) Depreciation increase
240,000 EBIT
(81,600) Taxes (34%)
158,400 EAT
0 Depreciation reversal
P 158,400 = Annual Cash Flow
For Years 6 - 8:
Problem 2
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Terminal Cash Flow:
P 40,000 Salvage value
(13,600) Tax on capital gain
15,000 Recapture of NWC
P 41,400 Terminal Cash Flow
Problem 2 Problem 2 Solution
NPV and IRR:
CF(0) = - P 590,000.00
CF(1 - 5) = P 197,500.00
CF(6 - 7) = P 158,400.00
CF(8) = P 158,400.00 + P 41,400.00 =
P 199,800.00
Discount rate = 14%.
IRR = 28.13% NPV = P 293,543.00
We would accept the project!
Replacement Project:
Old Asset (5 years old):
Cost of equipment = P 1,125,000.00
10-year project life, 10-year asset life.
Simplified straight line depreciation.
Current salvage value is P 400,000.00
Cost of capital = 14%, marginal tax
rate = 35%.
Problem 3
Replacement Project:
New Asset:
Cost of equipment = P 1,750,000.00
Shipping & installation will be P 56,000.00
P 68,000.00 investment in net working capital.
5-year project life, 5-year asset life.
Simplified straight line depreciation.
Will increase sales by P 285,000.00 per year.
Operating expenses will fall by P 100,000.00 per year.
Already paid P 15,000.00 for training program.
Salvage value after year 5 is P 500,000.00
Cost of capital = 14%, marginal tax rate = 34%.
Problem 3
Problem 3: Sell the Old Asset
Salvage value = P 400,000.00
Book value = depreciable asset - total
amount depreciated.
Book value = P 1,125,000.00 P 562,500.00
= P 562,500.00
Capital gain = SV - BV
= P 400,000.00 P 562,500.00 =
(P 162,500.00)
Tax refund = P 162,500.00 x .35 =
P 56,875.00
Problem 3
Initial Outlay:
(P 1,750,000) Cost of new machine
+ ( 56,000) Shipping & installation
(1,806,000) Depreciable asset
+ ( 68,000) NWC investment
+ 456,875 After-tax proceeds (sold
old machine)
(P 1,417,125) Net Initial Outlay
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P 385,000 Increased sales & cost savings
(248,700) Extra depreciation
136,300 EBT
(47,705) Taxes (35%)
88,595 EAT
248,700 Depreciation reversal
P 337,295 = Differential Cash Flow
For Years 1 - 5:
Problem 3
Terminal Cash Flow:
P 500,000 Salvage value
(175,000) Tax on capital gain
68,000 Recapture of NWC
P 393,000 Terminal Cash Flow
Problem 3
Problem 3 Solution
NPV and IRR:
CF(0) = - P 1,417,125.00
CF(1 - 4) = P 337,295.00
CF(5) = P 337,295.00 + P 393,000.00 =
P 730,295.00
Discount rate = 14%.
NPV = (P 55,052.07).
IRR = 12.55%.
We would not accept the project!