Chapter 8 Capital Budgeting Cash Flows Copyright 2009
Chapter 8 Capital Budgeting Cash Flows Copyright © 2009 Pearson Prentice Hall. All rights reserved.
Relevant Cash Flows: Sunk Costs Versus Opportunity Costs • Note that cash outlays already made (sunk costs) are irrelevant to the decision process. • However, opportunity costs, which are cash flows that could be realized from the best alternative use of the asset, are relevant. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -2
Relevant Cash Flows: International Capital Budgeting • International capital budgeting analysis differs from purely domestic analysis because: – cash inflows and outflows occur in a foreign currency, and – foreign investments potentially face significant political risks • Despite these risks, the pace of foreign direct investment has accelerated significantly since the end of WWII. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -3
Finding the Initial Investment Table 8. 2 The Basic Format for Determining Initial Investment Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -4
Finding the Initial Investment (cont. ) Table 8. 3 Tax Treatment on Sales of Assets Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -5
Finding the Initial Investment (cont. ) Hudson Industries, a small electronics company, 2 years ago acquired a machine tool with an installed cost of $100, 000. The asset was being depreciated under MACRS using a 5 -year recovery period. Thus 52% of the cost (20% + 32%) would represent accumulated depreciation at the end of year two. Book Value = $100, 000 - $52, 000 = $48, 000 Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -6
Finding the Initial Investment • Sale of the Asset for More Than Its Purchase Price If Hudson sells the old asset for $110, 000, it realizes a gain of $62, 000 ($110, 000 - $48, 000). Technically, the difference between the cost and book value ($52, 000) is called recaptured depreciation and the difference between the sales price and purchase price ($10, 000) is called a capital gain. Under current corporate tax laws, the firm must pay taxes on both the gain and recaptured depreciation at its marginal tax rate. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -7
Finding the Initial Investment (cont. ) • Sale of the Asset for More Than Its Book Value but Less than Its Purchase Price If Hudson sells the old asset for $70, 000, it realizes a gain in the form of recaptured depreciation of $22, 000 ($70, 000–$48, 000) which is taxed at the firm’s marginal tax rate. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -8
Finding the Initial Investment (cont. ) • Sale of the Asset for Its Book Value If Hudson sells the old asset for its book value of $48, 000, there is no gain or loss and therefore no tax implications from the sale. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -9
Finding the Initial Investment (cont. ) • Sale of the Asset for Less Than Its Book Value If Hudson sells the old asset for $30, 000 which is less than its book value of $48, 000, it experiences a loss of $18, 000 ($48, 000 - $30, 000). If this is a depreciable asset used in the business, the loss may be used to offset ordinary operating income. If it is not depreciable or used in the business, the loss can only e used to offset capital gains. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -10
Finding the Initial Investment (cont. ) Figure 8. 5 Taxable Income from Sale of Asset Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -11
Finding the Initial Investment (cont. ) • Change in Net Working Capital Danson Company, a metal products manufacturer, is contemplating expanding operations. Financial analysts expect that the changes in current accounts summarized in Table 8. 4 on the following slide will occur and will be maintained over the life of the expansion. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -12
Finding the Initial Investment (cont. ) Table 8. 4 Calculation of Change in Net Working Capital for Danson Company Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -13
Finding the Initial Investment (cont. ) Powell Corporation, a large diversified manufacturer of aircraft components, is trying to determine the initial investment required to replace an old machine with a new, more sophisticated model. The machine’s purchase price is $380, 000 and an additional $20, 000 will be necessary to install it. It will be depreciated under MACRS using a 5 -year recovery period. The firm has found a buyer willing to pay $280, 000 for the present machine and remove it at the buyers expense. The firm expects that a $35, 000 increase in current assets and an $18, 000 increase in current liabilities will accompany the replacement. Both ordinary income and capital gains are taxed at 40%. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -14
Finding the Initial Investment (cont. ) Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -15
Finding the Operating Cash Inflows Powell Corporation’s estimates of its revenues and expenses (excluding depreciation and interest), with and without the new machine described in the preceding example, are given in Table 8. 5. Note that both the expected usable life of the proposed machine and the remaining usable life of the existing machine are 5 years. The amount to be depreciated with the proposed machine is calculated by summing the purchase price of $380, 000 and the installation costs of $20, 000. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -16
Finding the Operating Cash Inflows (cont. ) Table 8. 5 Powell Corporation’s Revenue and Expenses (Excluding Depreciation and Interest) for Proposed and Present Machines Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -17
Table 8. 6 Depreciation Expense for Proposed and Present Machines for Powell Corporation Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -18
Table 8. 7 Calculation of Operating Cash Inflows Using the Income Statement Format Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -19
Table 8. 8 Calculation of Operating Cash Inflows for Powell Corporation’s Proposed and Present Machines Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -20
Table 8. 9 Incremental (Relevant) Operating Cash Inflows for Powell Corporation Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -21
Finding the Terminal Cash Flow Table 8. 10 The Basic Format for Determining Terminal Cash Flow Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -22
Finding the Terminal Cash Flow (cont. ) Continuing with the Powell Corporation example, assume that the firm expects to be able to liquidate the new machine at the end of its 5 -year useable life to net $50, 000 after paying removal and cleanup costs. The old machine can be liquidated at the end of the 5 years to net $10, 000. The firm expects to recover its $17, 000 net working capital investment upon termination of the project. Again, the tax rate is 40%. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -23
Finding the Terminal Cash Flow (cont. ) Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -24
Summarizing the Relevant Cash Flows Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 -25
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