Capital Budgeting Process PDF

FUNO_C12.qxd 9/19/08 14:03 Page 308 Part 5 Investment in Capital Assets The Capital Budgeting Process: An Overview Having just explored ways to efficiently manage working capital (current assets and their supporting f...

FUNO_C12.qxd 9/19/08 14:03 Page 308 Part 5 Investment in Capital Assets The Capital Budgeting Process: An Overview Having just explored ways to efficiently manage working capital (current assets and their supporting financing), we now turn our attention to decisions that involve long-lived assets. These decisions involve both investment and financing choices, the first of which takes up the next three chapters. When a business makes a capital investment, it incurs a current cash outlay in the expecta- tion of future benefits. Usually, these benefits extend beyond one year in the future. Examples include investment in assets, such as equipment, buildings, and land, as well as the introduc- tion of a new product, a new distribution system, or a new program for research and develop- ment. In short, the firm’s future success and profitability depend on long-term decisions currently made. An investment proposal should be judged in relation to whether or not it provides a return equal to, or greater than, that required by investors.1 To simplify our investigation of the Capital budgeting methods of capital budgeting in this and the following chapter, we assume that the required The process of return is given and is the same for all investment projects. This assumption implies that the identifying, analyzing, selection of any investment project does not alter the operating, or business-risk, complexion and selecting investment projects of the firm as perceived by financing suppliers. In Chapter 15 we investigate how to determine whose returns (cash the required rate of return, and in Chapter 14 we allow for the fact that different investment flows) are expected projects have different degrees of business risk. As a result, the selection of an investment to extend beyond project may affect the business-risk complexion of the firm, which, in turn, may affect the rate one year. of return required by investors. For purposes of introducing capital budgeting in this and the next chapter, however, we hold risk constant. Take Note Capital budgeting involves l Generating investment project proposals consistent with the firm’s strategic objectives l Estimating after-tax incremental operating cash flows for investment projects l Evaluating project incremental cash flows l Selecting projects based on a value-maximizing acceptance criterion l Reevaluating implemented investment projects continually and performing postaudits for completed projects In this chapter, we restrict ourselves to a discussion of the first two items on this list. Generating Investment Project Proposals Investment project proposals can stem from a variety of sources. For purposes of analysis, projects may be classified into one of five categories: 1. New products or expansion of existing products 2. Replacement of equipment or buildings 3. Research and development 4. Exploration 5. Other (for example, safety-related or pollution-control devices) 1 The development of the material on capital budgeting assumes that the reader understands the concepts covered in Chapter 3 on the time value of money. 308 FUNO_C12.qxd 9/19/08 14:03 Page 309 12 Capital Budgeting and Estimating Cash Flows For a new product, the proposal usually originates in the marketing department. A proposal to replace a piece of equipment with a more sophisticated model, however, usually arises from the production area of the firm. In each case, efficient administrative procedures are needed for channeling investment requests. All investment requests should be consistent with corporate strategy to avoid needless analysis of projects incompatible with this strategy. (McDonald’s probably would not want to sell cigarettes in its restaurants, for example.) Most firms screen proposals at multiple levels of authority. For a proposal originating in the production area, the hierarchy of authority might run (1) from section chiefs, (2) to plant managers, (3) to the vice president for operations, (4) to a capital expenditures committee under the financial manager, (5) to the president, and (6) to the board of directors. How high a proposal must go before it is finally approved usually depends on its cost. The greater the capital outlay, the greater the number of “screens” usually required. Plant managers may be able to approve moderate-sized projects on their own, but only higher levels of authority approve larger ones. Because the administrative procedures for screening investment pro- posals vary from firm to firm, it is not possible to generalize. The best procedure will depend on the circumstances. It is clear, however, that companies are becoming increasingly sophis- ticated in their approach to capital budgeting. Estimating Project “After-Tax Incremental Operating Cash Flows” l l l Cash-Flow Checklist One of the most important tasks in capital budgeting is estimating future cash flows for a project. The final results we obtain from our analysis are no better than the accuracy of our cash-flow estimates. Because cash, not accounting income, is central to all decisions of the firm, we express whatever benefits we expect from a project in terms of cash flows rather than income flows. The firm invests cash now in the hope of receiving even greater cash returns in the future. Only cash can be reinvested in the firm or paid to shareholders in the form of dividends. In capital budgeting, good guys may get credit, but effective managers get cash. In setting up the cash flows for analysis, a computer spreadsheet program is invaluable. It allows one to change assumptions and quickly produce a new cash-flow stream. Take Note For each investment proposal we need to provide information on operating, as opposed to financing, cash flows. Financing flows, such as interest payments, principal payments, and cash dividends, are excluded from our cash-flow analysis. However, the need for an invest- ment’s return to cover capital costs is not ignored. The use of a discount (or hurdle) rate equal to the required rate of return of capital suppliers will capture the financing cost dimen- sion. We will discuss the mechanics of this type of analysis in the next chapter. Cash flows should be determined on an after-tax basis. The initial investment outlay, as well as the appropriate discount rate, will be expressed in after-tax terms. Therefore all fore- casted flows need to be stated on an equivalent, after-tax basis. In addition, the information must be presented on an incremental basis, so that we analyze only the difference between the cash flows of the firm with and without the project. For example, if a firm contemplates a new product that is likely to compete with existing products, it is not appropriate to express cash flows in terms of estimated total sales of the new product. We must take into account the probable “cannibalization” of existing products and make our cash-flow estimates on the basis of incremental sales. When continuation of the 309 FUNO_C12.qxd 9/19/08 14:03 Page 310 Part 5 Investment in Capital Assets status quo results in loss of market share, we must take this into account when analyzing what happens if we do not make a new investment. That is, if cash flows will erode if we do not invest, we must factor this into our analysis. The key is to analyze the situation with and with- out the new investment and where all relevant costs and benefits are brought into play. Only incremental cash flows matter. Sunk costs In this regard, sunk costs must be ignored. Our concern lies with incremental costs and Unrecoverable past benefits. Unrecoverable past costs are irrelevant and should not enter into the decision pro- outlays that, as they cess. Also, we must be mindful that certain relevant costs do not necessarily involve an actual cannot be recovered, should not affect dollar outlay. If we have allocated plant space to a project and this space can be used for some- present actions or thing else, its opportunity cost must be included in the project’s evaluation. If a currently future decisions. unused building needed for a project can be sold for $300,000, that amount (net of any taxes) Opportunity cost should be treated as if it were a cash outlay at the outset of the project. Thus, in deriving cash What is lost by not flows, we need to consider any appropriate opportunity costs. taking the next-best When a capital investment contains a current asset component, this component (net of any investment spontaneous changes in current liabilities) is treated as part of the capital investment and not alternative. as a separate working capital decision. For example, with the acceptance of a new project it is sometimes necessary to carry additional cash, receivables, or inventories. This investment in working capital should be treated as a cash outflow at the time it occurs. At the end of a project’s life, the working capital investment is presumably returned in the form of an addi- tional cash inflow. In estimating cash flows, anticipated inflation must be taken into account. Often there is a tendency to assume erroneously that price levels will remain unchanged throughout the life of a project. If the required rate of return for a project to be accepted embodies a premium for inflation (as it usually does), then estimated cash flows must also reflect inflation. Such cash flows are affected in several ways. If cash inflows ultimately arise from the sale of a product, expected future prices affect these inflows. As for cash outflows, inflation affects both expected future wages and material costs. Table 12.1 summarizes the major concerns to keep in mind as we prepare to actually deter- mine project “after-tax incremental operating cash flows.” It provides us with a “checklist” for determining cash-flow estimates. l l l Tax Considerations Method of Depreciation. As you may remember from Chapter 2, depreciation is the sys- tematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both. Because depreciation deductions taken on a firm’s tax return Table 12.1 BASIC CHARACTERISTICS OF RELEVANT PROJECT FLOWS Cash-flow checklist o 3 Cash (not accounting income) flows o 3 Operating (not financing) flows o 3 After-tax flows o 3 Incremental flows BASIC PRINCIPLES THAT MUST BE ADHERED TO IN ESTIMATING “AFTER-TAX INCREMENTAL OPERATING CASH FLOWS” o 3 Ignore sunk costs o 3 Include opportunity costs o 3 Include project-driven changes in working capital net of spontaneous changes in current liabilities o 3 Include effects of inflation 310 FUNO_C12.qxd 9/19/08 14:03 Page 311 12 Capital Budgeting and Estimating Cash Flows Table 12.2 PROPERTY CLASS RECOVERY MACRS depreciation YEAR 3-YEAR 5-YEAR 7-YEAR 10-YEAR percentages 1 33.33% 20.00% 14.29% 10.00% 2 44.45 32.00 24.49 18.00 3 14.81 19.20 17.49 14.40 4 7.41 11.52 12.49 11.52 5 11.52 8.93 9.22 6 5.76 8.92 7.37 7 8.93 6.55 8 4.46 6.55 9 6.56 10 6.55 11 3.28 Totals 100.00% 100.00% 100.00% 100.00% are treated as expense items, depreciation lowers taxable income. Everything else being equal, the greater the depreciation charges, the lower the taxes paid. Although depreciation itself is a noncash expense, it does affect the firm’s cash flow by directly influencing the cash outflow of taxes paid. There are a number of alternative procedures that may be used to depreciate capital assets. These include straight-line and various accelerated depreciation methods. Most profitable firms prefer to use an accelerated depreciation method for tax purposes – one that allows for a more rapid write-off and, therefore, a lower tax bill. The Tax Reform Act of 1986 allows companies to use a particular type of accelerated depre- ciation for tax purposes known as the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, machinery, equipment, and real estate are assigned to one of eight classes for cost recovery (depreciation) purposes. As described in Chapter 2, the property category in which an asset falls determines its depreciable life for tax purposes. As also described in that chapter, the half-year convention must generally be applied to all machinery and equipment. There is a half-year of depreciation in the year an asset is acquired and in the final year that depreciation is taken on the asset. The Treasury publishes depreciation percentages of original cost for each property class, which incorporate the half-year conventions. Table 12.2 presents the depreciation percentages for the first four property classes. These percentages correspond to the principles taken up in Chapter 2, and they should be used for determining depreciation. Take Note In Chapter 2, we noted that the “temporary” first-year 50 percent “bonus depreciation” provision allowed under the recently enacted US Economic Stimulus Act (ESA) of 2008 would affect a company’s federal tax payments and capital budgeting decisions. However, this “bonus depreciation” provision is scheduled to expire by the end of 2008. Therefore, all of our examples and problems involving MACRS depreciation will ignore the “bonus depreciation” provision. But remember, a “temporary” bonus depreciation provision may very well return again in your professional future – so be prepared. To learn more about the first-year 50 percent “bonus depreciation” provision under ESA visit: (web.utk.edu/~jwachowi/hr5140.html). And, to learn more about earlier “bonus depreciation” provisions visit the following web- sites: Job Creation and Worker Assistance Act of 2002 (web.utk.edu/~jwachowi/hr3090.html) and Jobs and Growth Tax Relief Reconciliation Act of 2003 (web.utk.edu/~jwachowi/hr2.html). 311 FUNO_C12.qxd 9/19/08 14:03 Page 312 Part 5 Investment in Capital Assets Question Can MACRS depreciation be utilized by US companies on equipment used outside the United States? Answer 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). Take Note Depreciable Basis. Computing depreciation for an asset requires a determination of the Depreciable basis asset’s depreciable basis. This is the amount that taxing authorities allow to be written off In tax accounting, the for tax purposes over a period of years. The cost of the asset, including any other capitalized fully installed cost of expenditures – such as shipping and installation – that are incurred to prepare the asset for an asset. This is the its intended use, constitutes the asset’s depreciable basis under MACRS. Notice that under amount that, by law, may be written off MACRS the asset’s depreciable basis is not reduced by the estimated salvage value of the asset. over time for tax purposes. Capitalized Sale or Disposal of a Depreciable Asset. In general, if a depreciable asset used in busi- expenditures ness is sold for more than its depreciated (tax) book value, any amount realized in excess of Expenditures that book value but less than the asset’s depreciable basis is considered a “recapture of deprecia- may provide benefits tion” and is taxed at the firm’s ordinary income tax rate. This effectively reverses any positive into the future and therefore are treated tax benefits of having taken “too much” depreciation in earlier years – that is, reducing (tax) as capital outlays and book value below market value. If the asset happens to sell for more than its depreciable basis not as expenses of (which, by the way, is not too likely), the portion of the total amount in excess of the depre- the period in which ciable basis is taxed at the capital gains tax rate (which currently is equal to the firm’s ordinary they were incurred. income tax rate, or a maximum of 35 percent). If the asset sells for less than (tax) book value, a loss is incurred equal to the difference between sales price and (tax) book value. In general, this loss is deducted from the firm’s ordin- ary income. In effect, an amount of taxable income equal to the loss is “shielded” from being taxed. The net result is a tax-shield savings equal to the firm’s ordinary tax rate multiplied by the loss on the sale of the depreciable asset. Thus a “paper” loss is cause for a “cash” savings. Our discussion on the tax consequences of the sale of a depreciable asset has assumed no additional complicating factors. In actuality, a number of complications can and often do occur. Therefore the reader is cautioned to refer to the tax code and/or a tax specialist when faced with the tax treatment of a sale of an asset. In examples and problems, for ease of calculation we will generally use a 40 percent marginal ordinary income tax rate. l l l Calculating the Incremental Cash Flows We now face the task of identifying the specific components that determine a project’s rele- vant cash flows. We need to keep in mind both the concerns enumerated in our “cash-flow checklist” (Table 12.1) as well as the various tax considerations just discussed. It is helpful to place project cash flows into three categories based on timing: 1. Initial cash outflow: the initial net cash investment. 2. Interim incremental net cash flows: those net cash flows occurring after the initial cash investment but not including the final period’s cash flow. 312 FUNO_C12.qxd 9/19/08 14:03 Page 313 12 Capital Budgeting and Estimating Cash Flows 3. Terminal-year incremental net cash flow: the final period’s net cash flow. (This period’s cash flow is singled out for special attention because a particular set of cash flows often occurs at project termination.) Initial Cash Outflow. In general, the initial cash outflow for a project is determined as follows in Table 12.3. As seen, the cost of the asset is subject to adjustments to reflect the totality of cash flows associated with its acquisition. These cash flows include installation costs, changes in net working capital, sale proceeds from the disposition of any assets replaced, and tax adjustments. Interim Incremental Net Cash Flows. After making the initial cash outflow that is neces- sary to begin implementing a project, the firm hopes to benefit from the future cash inflows generated by the project. Generally, these future cash flows can be determined by following the step-by-step procedure outlined in Table 12.4. Notice that we first deduct any increase (add any decrease) in incremental tax deprecia- tion related to project acceptance – see step (b) – in determining the “net change in income before taxes.” However, a few steps later we add back any increase (deduct any decrease) in tax depreciation – see step (f) – in determining “incremental net cash flow for the period.” What is going on here? Well, tax depreciation itself, as you may remember, is a noncash charge against operating income that lowers taxable income. So we need to consider it as we determine the incremental effect that project acceptance has on the firm’s taxes. However, we ultimately need to add back any increase (subtract any decrease) in tax depreciation to our resulting “net change in income after taxes” figure so as not to understate the project’s effect on cash flow. Table 12.3 (a) Cost of “new” asset(s) Basic format for (b) + Capitalized expenditures (for example, installation costs, shipping expenses, etc.)* determining initial cash outflow (c) +(−) Increased (decreased) level of “net” working capital** (d) − Net proceeds from sale of “old” asset(s) if the investment is a replacement decision (e) +(−) Taxes (tax savings) due to the sale of “old” asset(s) if the investment is a replacement decision (f) = Initial cash outflow *Asset cost plus capitalized expenditures form the basis on which tax depreciation is computed. **Any change in working capital should be considered “net” of any spontaneous changes in current liabilities that occur because the project is implemented. Table 12.4 (a) Net increase (decrease) in operating revenue less (plus) any net increase (decrease) in Basic format for operating expenses, excluding depreciation determining interim (b) −(+) Net increase (decrease) in tax depreciation charges incremental net cash flow (per period) (c) = Net change in income before taxes (d) −(+) Net increase (decrease) in taxes (e) = Net change in income after taxes (f) +(−) Net increase (decrease) in tax depreciation charges (g) = Incremental net cash flow for the period 313 FUNO_C12.qxd 9/19/08 14:03 Page 314 Part 5 Investment in Capital Assets Table 12.5 (a) Net increase (decrease) in operating revenue less (plus) any net increase (decrease) in Basic format for operating expenses, excluding depreciation determining terminal (b) −(+) Net increase (decrease) in tax depreciation charges year incremental net cash flow (c) = Net change in income before taxes (d) −(+) Net increase (decrease) in taxes (e) = Net change in income after taxes (f) +(−) Net increase (decrease) in tax depreciation charges (g) = Incremental cash flow for the terminal year before project windup considerations (h) +(−) Final salvage value (disposal/reclamation costs) of “new” asset(s) (i) −(+) Taxes (tax savings) due to sale or disposal of “new” asset(s) (j) +(−) Decreased (increased) level of “net” working capital* (k) = Terminal year incremental net cash flow *Any change in working capital should be considered “net” of any spontaneous changes in current liabilities that occur because the project is terminated. Take Note Project-related changes in working capital are more likely to occur at project inception and termination. Therefore Table 12.4 does not show a separate, recurring adjustment for working capital changes. However, for any interim period in which a material change in working capital occurs, we would need to adjust our basic calculation. We should therefore include an additional step in the “interim incremental net cash flow” determination. The following line item would then appear right after step (f ): + (−) Decreased (increased) level of “net” working capital – with any change in working capital being considered “net” of any spontaneous changes in current liabilities caused by the project in this period. Terminal-Year Incremental Net Cash Flow. Finally, we turn our attention to determin- ing the project’s incremental cash flow in its final, or terminal, year of existence. We apply the same step-by-step procedure for this period’s cash flow as we did to those in all the interim periods. In addition, we give special recognition to a few cash flows that are often connected only with project termination. These potential project windup cash flows are (1) the salvage value (disposal/reclamation costs) of any sold or disposed assets, (2) taxes (tax savings) related to asset sale or disposal, and (3) any project-termination-related change in working capital – generally, any initial working capital investment is now returned as an additional cash inflow. Table 12.5 summarizes all the necessary steps and highlights those steps that are reserved especially for project termination. l l l Example of Asset Expansion To illustrate the information needed for a capital budgeting decision, we examine the follow- ing situation. The Faversham Fish Farm is considering the introduction of a new fish-flaking facility. To launch the facility, it will need to spend $90,000 for special equipment. The equip- ment has a useful life of four years and is in the three-year property class for tax purposes. Shipping and installation expenditures equal $10,000, and the machinery has an expected final salvage value, four years from now, of $16,500. The machinery is to be housed in an abandoned warehouse next to the main processing plant. The old warehouse has no alterna- tive economic use. No additional “net” working capital is needed. The marketing department 314 FUNO_C12.qxd 9/19/08 14:03 Page 315 12 Capital Budgeting and Estimating Cash Flows envisions that use of the new facility will generate additional net operating revenue cash flows, before consideration of depreciation and taxes, as follows: END OF YEAR 1 2 3 4 Net cash flows $35,167 $36,250 $55,725 $32,258 Assuming that the marginal tax rate equals 40 percent, we now need to estimate the project’s relevant incremental cash flows. The first step is to estimate the project’s initial cash outflow: Step A: Estimating initial cash outflow Cost of “new” asset(s) $ 90,000 + Capitalized expenditures (shipping and installation) 10,000 = Initial cash outflow $100,000 The next steps involve calculating the incremental future cash flows. END OF YEAR 1 2 3 4 Step B: Calculating interim incremental net cash flows (years 1 to 3) Net change in operating revenue, excluding depreciation $35,167 $36,250 $55,725 $32,258 − Net increase in tax depreciation chargesa (33,330) (44,450) (14,810) (7,410) = Net change in income before taxes $ 1,837 $ (8,200) $40,915 $24,848 −(+) Net increase (decrease) in taxes (40% rate) (735) 3,280b (16,366) (9,939) = Net change in income after taxes $ 1,102 $ (4,920) $24,549 $14,909 + Net increase in tax depreciation charges 33,330 44,450 14,810 7,410 = Incremental net cash flow for years 1 to 3 $34,432 $39,530 $39,359 Step C: Calculating terminal-year incremental net cash flow = Incremental cash flow for the terminal year before project windup considerations $22,319 + Final salvage value of “new” asset(s) 16,500 − Taxes due to sale or disposal of “new” asset(s) (6,600)c = Terminal-year incremental net cash flow $32,219 a MACRS depreciation percentages for 3-year property class asset applied against asset with a depreciable basis of $100,000. b Assumes that tax loss shields other income of the firm. c Assumes salvage value is recapture of depreciation and taxed at ordinary income rate of 40 percent – $16,500(0.40) = $6,600. The expected incremental net cash flows from the project are END OF YEAR 0 1 2 3 4 Net cash flows ($100,000) $34,432 $39,530 $39,359 $32,219 Thus, for an initial cash outflow of $100,000, the firm expects to generate net cash flows of $34,432, $39,530, $39,359, and $32,219 over the next four years. This data represents the relevant cash-flow information that we need to judge the attractiveness of the project. 315 FUNO_C12.qxd 9/19/08 14:03 Page 316 Part 5 Investment in Capital Assets By now, you are probably dying to know whether the Faversham Fish Farm should favor the fish-flaking facility. However, we will leave the analysis of these cash flows until the next chapter. Our concern here has been simply to determine the relevant cash-flow information needed. For the time being then, this expansion example must remain “to be continued in Chapter 13.” l l l Example of Asset Replacement To go to a somewhat more complicated example, we suppose that we are considering the purchase of a new automotive-glass mold to replace an old mold and that we need to obtain cash-flow information to evaluate the attractiveness of this project. The purchase price of the new mold is $18,500, and it will require an additional $1,500 to install, bringing the total cost to $20,000. The old mold, which has a remaining useful life of four years, can be sold for its depreciated (tax) book value of $2,000. The old mold would have no salvage value if held to the end of its useful life. Notice that, as salvage value equals tax book value, taxes due to the sale of the old asset are zero. The initial cash outflow for the investment project, therefore, is $18,000 as follows: Cost of “new” asset $18,500 + Capitalized expenditures (shipping and installation) 1,500 − Net proceeds from sale of “old” asset (2,000) + Taxes (tax savings) due to sale of “old” asset 0 = Initial cash outflow $18,000 The new machine should cut labor and maintenance costs and produce other cash savings totaling $7,100 a year before taxes for each of the next four years, after which it will probably not provide any savings nor have a salvage value. These savings represent the net operating revenue savings to the firm if it replaces the old mold with the new one. Remember, we are concerned with the differences in the cash flows resulting from continuing to use the old mold versus replacing it with a new one. Suppose that the new mold we are considering falls into the three-year property category for MACRS depreciation. Moreover, assume the following in regards to the old mold: 1. The original depreciable basis was $9,000. 2. The mold fell into the three-year property class. 3. The remaining depreciable life is two years. Because we are interested in the incremental impact of the project, we must subtract depre- ciation charges on the old mold from depreciation charges on the new one to obtain the incre- mental depreciation charges associated with the project. Given the information provided plus the appropriate MACRS depreciation percentages, we are able to calculate the difference in depreciation charges resulting from the acceptance of the project. The necessary calculations are as follows: YEAR 1 2 3 4 (a) New mold’s depreciable basis $20,000 $20,000 $20,000 $20,000 (b) × MACRS depreciation (%) × 0.3333 × 0.4445 × 0.1481 × 0.0741 (c) = New mold’s periodic depreciation $ 6,666 $ 8,890 $ 2,962 $ 1,482 (d) Old mold’s depreciable basis $ 9,000 $ 9,000 $ 9,000 $ 9,000 (e) × MACRS depreciation (%) × 0.1481 × 0.0741 ×0 ×0 (f) = Old mold’s remaining periodic depreciation $ 1,333 $ 667 $ 0 $ 0 (g) Net increase in tax depreciation charges Line (c) − Line (f ) $ 5,333 $ 8,223 $ 2,962 $ 1,482 316 FUNO_C12.qxd 9/19/08 14:03 Page 317 12 Capital Budgeting and Estimating Cash Flows We can now calculate the future incremental cash flows as follows: END OF YEAR 1 2 3 4 Interim incremental net cash flows (years 1 to 3) Net change in operating revenue, excluding depreciation $7,100 $ 7,100 $7,100 $7,100 − Net increase in tax depreciation charges (5,333) (8,223) (2,962) (1,482) = Net change in income before taxes $1,767 $(1,123) $4,138 $5,618 −(+) Net increase (decrease) in taxes (40% rate) (707) 449a (1,655) (2,247) = Net change in income after taxes $1,060 $ (674) $2,483 $3,371 + Net increase in tax depreciation charges 5,333 8,223 2,962 1,482 = Incremental net cash flow for years 1 to 3 $6,393 $ 7,549 $5,445 Terminal-year incremental net cash flow = Incremental cash flow for the terminal year before project windup considerations $4,853 + Final salvage value of “new” asset 0 − Taxes (tax savings) due to sale or disposal of “new”asset 0 = Terminal-year incremental net cash flow $4,853 a Assumes that tax loss shields other income of the firm. The expected incremental net cash flows from the replacement project are: END OF YEAR 0 1 2 3 4 Net cash flows ($18,000) $6,393 $7,549 $5,445 $4,853 For an initial cash outflow of $18,000, then, we are able to replace an old glass mold with a new one that is expected to result in net cash flows of $6,393, $7,549, $5,445, and $4,853 over the next four years. As in the previous example, the relevant cash-flow information for capital budgeting purposes is expressed on an incremental, after-tax basis. l l l End of the Beginning In this chapter we considered how to generate investment project proposals and how to estimate the relevant cash-flow information needed to evaluate investment proposals. In the next chapter we continue our discussion of the capital budgeting process. There you will learn how to evaluate project incremental cash flows and how to determine which projects should be accepted. 317