Capital Budgeting Is The Decision-Making

Chapter 9
Introduction
 Capital budgeting is the decision-making
process used in the acquisition of long-term
physical assets.
 Traditional capital budgeting projects include
decisions to invest in the following:
 A new hotel
 A casino expansion
 Addition of a bar to a restaurant
 Replacement of a sprinkler system at a hotel
Hospitality Financial Management ©2005 Pearson Education, Inc.
By Robert E. Chatfield and Michael C. Dalbor 9-1 Pearson Prentice Hall
Upper Saddle River, NJ 07458
Chapter 9
Introduction
 Capital budgeting decisions are crucial to a
firm’s long-term financial health.
 Successful capital budgeting projects usually generate a
positive cash flow for a long period of time.
 Unsuccessful capital budgeting projects do not return

sufficient cash flow to justify the investment. Such
projects usually continue to generate losses or are
liquidated for a large one-time loss.
 Capital budgeting decisions set a firm’s future course by

determining what services will be offered, how they will
be offered, and where they will be offered.
Organization of Chapter 9
 Different types of capital budgeting projects;

classification of projects by purpose and by
type of analysis
 Project cash flows and principles of cash flow

estimation
 Project cost—net investment estimation

Organization of Chapter 9
 A project’s future cash inflows—net cash flow

estimation
 Project termination—after-tax salvage value

estimation
 Project depreciation and its impact on cash

flow

Classifying Capital Budgeting Projects
 The purpose of a project may be to:

 Grow the firm causing future sales, profits, and cash
flows to increase; includes typical expansion projects.
 Reduce the firm’s future operating costs causing future

profits and cash flows to increase; examples include
new, more efficient air conditioners or new kitchen
equipment requiring less maintenance.
 Meet legal requirements or satisfy ethical

considerations; examples include fire alarm and fire
suppression systems.
 Independent versus mutually exclusive

projects.
 An independent project requires a stand-alone
decision. The project is analyzed in isolation
and not compared to other projects. An
example is a proposal to add a new 200-room
tower to a hotel.

 Mutually exclusive projects require a choice

between two or more projects. For example, a
decision to replace the air conditioning system
with brand x, brand y, or brand z is a mutually
exclusive decision. If you decide to invest in a
new air conditioning system by brand x, then
brands y and z have been excluded!

Project Cash Flows
 Estimating a project’s impact on a firm’s future
cash flows is a crucial part of the investment
decision. Some basic principles need to be
followed when estimating a project’s cash flows:
 An incremental basis
 An after-tax basis
 Indirect effects should be included
 Costs should be measured as opportunity costs and not
based upon historical or sunk costs

Project Cash Flows
 The capital budgeting decision is essentially
based upon a cost/benefit analysis.
 The cost of a project is called the net

investment.
 The benefits from a project are the future

cash flows generated. We call these the
net cash flows.
Net Investment
 The net cash outflows required to ready a
project for its basic operation; the net
investment includes:
 Cost of any assets

 + Delivery costs
 + Installation costs
 + Any required increase in net working capital
 – After-tax salvage value from replaced assets

Net Cash Flows
 These are the future cash flows generated from
a project once it commences operation. The
net cash flows are expected to continue
throughout the project’s economic life.
 The net cash flow for each year is:

  Earnings before taxes x (1 – t)
 +  Depreciation
 -  Net working capital

Net Cash Flows
 And  Earnings before taxes is estimated by:
  Sales revenue
 –  Operating expenses
 –  Depreciation
 Interest expense is generally not included in the net

cash flows since it will be taken into account later
through the firm’s required rate of return.

Terminal Nonoperating Cash Flow
 These are special one-time cash flows that only
occur at the end of a project’s life. They are
added to a project’s last net cash flow. They
include:
 After-tax salvage value of the project’s

assets
 Return of any increased net working capital

Computation of After-Tax Salvage Values
 Taxes owed on salvage value depend upon the

salvage price relative to the asset’s book value.
 As asset’s book value is the asset’s original

acquisition cost minus all depreciation taken on
the asset (accumulated depreciation).

Computation of After-Tax Salvage Values
 If an asset is sold for its book value then no
taxes are owed.
 If an asset is sold for more than book value,

then taxes are owed on this excess.
 If an asset is sold for less than book value, then

taxes are reduced. The loss acts as a tax
shelter, reducing taxes by an amount equal to
the firm’s marginal tax rate times the deficit.

Depreciation
 The depreciation actually affecting cash flow is
MACRS depreciation used for taxes.
 MACRS depreciation varies by type of asset but

always depreciates to a zero value, not an
estimated salvage value.
 Here we will simplify by assuming straight-line

depreciation to a zero value.

Depreciation
 Depreciation shelters income from taxes.
 Thus, greater depreciation reduces taxes.
 Depreciation is not an out-of-pocket expense.
 Thus an increase in depreciation will reduce

profit but increase cash flow.

Summary of Chapter 9 Topics
 The significance of good capital budgeting
decisions to a firm’s long-term financial health
 Projects can be classified according to:
 Purpose
 Independent versus mutually exclusive

decisions

Summary of Chapter 9 Topics
 The cash flows associated with a project are
crucial to the investment decision. They
include:
 Net investment
 Net cash flows
 Terminal nonoperating cash flows


Capital Budgeting Is The Decision-Making

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Capital Budgeting Is The Decision-Making

Uploaded by

Copyright:

Available Formats

Chapter 9

 Unsuccessful capital budgeting projects do not return

 Capital budgeting decisions set a firm’s future course by

 Different types of capital budgeting projects;

 Project cash flows and principles of cash flow

 Project cost—net investment estimation

Hospitality Financial Management ©2005 Pearson Education, Inc.

 A project’s future cash inflows—net cash flow

 Project termination—after-tax salvage value

 Project depreciation and its impact on cash

Hospitality Financial Management ©2005 Pearson Education, Inc.

 The purpose of a project may be to:

 Reduce the firm’s future operating costs causing future

 Meet legal requirements or satisfy ethical

 Independent versus mutually exclusive

Hospitality Financial Management ©2005 Pearson Education, Inc.

 Mutually exclusive projects require a choice

Hospitality Financial Management ©2005 Pearson Education, Inc.

Hospitality Financial Management ©2005 Pearson Education, Inc.

 The cost of a project is called the net

 The benefits from a project are the future

 Cost of any assets

Hospitality Financial Management ©2005 Pearson Education, Inc.

 The net cash flow for each year is:

Hospitality Financial Management ©2005 Pearson Education, Inc.

 Interest expense is generally not included in the net

Hospitality Financial Management ©2005 Pearson Education, Inc.

 After-tax salvage value of the project’s

 Return of any increased net working capital

Hospitality Financial Management ©2005 Pearson Education, Inc.

 Taxes owed on salvage value depend upon the

 As asset’s book value is the asset’s original

Hospitality Financial Management ©2005 Pearson Education, Inc.

 If an asset is sold for more than book value,

 If an asset is sold for less than book value, then

Hospitality Financial Management ©2005 Pearson Education, Inc.

 MACRS depreciation varies by type of asset but

 Here we will simplify by assuming straight-line

Hospitality Financial Management ©2005 Pearson Education, Inc.

 Thus, greater depreciation reduces taxes.

 Depreciation is not an out-of-pocket expense.

 Thus an increase in depreciation will reduce

Hospitality Financial Management ©2005 Pearson Education, Inc.

 Projects can be classified according to:

 Independent versus mutually exclusive

Hospitality Financial Management ©2005 Pearson Education, Inc.

 Net cash flows

 Terminal nonoperating cash flows

Hospitality Financial Management ©2005 Pearson Education, Inc.

You might also like