Capital Budgeting 2
Capital Budgeting 2 •
Calculate the relevant incremental cash flows for capital budgeting Quality of NPV = reflection of quality of cash flow estimates Must decide what is a cash flow item and whether it is incremental or not *Incremental CF’s are changes in CF’s that occur from accepting project If a CF doesn’t change, we don’t include it in our analysis Aka direct consequence of taking the project/investment
$7 = diverging sales (existing sales lost) *Cannibalisation (erosion)
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Difference accounting & finance views of capital budgeting Financial manager is interested in timing of CF’s, not revenue/expenses Why financing cash flows & sunk costs shouldn’t be included Sunk cost: Expense paid previously and cannot be recovered (irrelevant) Financing cost: Interest payments (already included into discount rate) so therefore not included, as they would be double counted. Only interested in the CF’s generated by the assets of the project. Understand opportunity cost and cash flow implications Opportunity cost: CF’s an asset could generate if not used in a proposed investment. (Requires us to give up a benefit) -‐ Go at the start of cash flows E.g. market value is an opportunity cost and an incremental cash flow Using land to build on that has a market value of $7m Calculate the various tax effects (e.g. depreciation, disposal, capital gains) for calculating different cash flow estimates Company taxes: Major outflow for firms (taxes incurred paid in same yr) Operating revenue = taxable & Operating costs = tax deductible *Purchase of assets are not tax deductible at time of purchase but depreciation is allowed as a tax deduction Tax effect – CF during the life
*Net after-‐tax CF = Pre tax cash flow (1 – tc) x depreciation tax saving Higher depreciable = lower taxes payable *Depreciation tax saving = Depreciation x Tc Depreciation is not a cash expense (not including in cash flows) Charge = expense *300 = benefit from depreciation expense * Book value of an asset (WDV) = Initial cost – Accumulated Depreciation •
Tax effect on sale of asset Sale incurs tax if salvage value and book value are different If Salvage value > Book value = Taxable profit *Tax on sale (WDV – salvage value) x Tc Annual Depreciation = 100000/10 = $10 000 Book Value today = 100 000 – 5(10 000) = $50 000 5(10 000) = Accumulated Depreciation
Loss = 50 000 – 20 000 = $ 30 000 (tax saving = 30 000 x 0.3 = $9000) *If WDV > Salvage value = firm claimed too little depreciation & the government owes the company a tax refund •
Calculate NPV for a project ! Cash flows at the start: * Don’t only include purchase of plant/equipment -‐ Alterations to building/installation costs -‐ Proceeds from the sale of old machinery (replacement decision) -‐ Investment in working capital (e.g. inventory) -‐ Market value of assets owned that are to be used in the project (opportunity cost – e.g. tools to be transferred from old plant) * If a capital expenditure proposal results in a decrease in the amount of inventory then initial cash flows is reduced by the inventory change. ! Cash flows throughout life: -‐ Selling expenses for the new product -‐ Tax savings from deprecation allows on new machine
Calculate the relevant incremental cash flows for capital budgeting Quality of NPV = reflection of quality of cash flow estimates Must decide what is a cash flow item and whether it is incremental or not *Incremental CF’s are changes in CF’s that occur from accepting project If a CF doesn’t change, we don’t include it in our analysis Aka direct consequence of taking the project/investment
$7 = diverging sales (existing sales lost) *Cannibalisation (erosion)
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Difference accounting & finance views of capital budgeting Financial manager is interested in timing of CF’s, not revenue/expenses Why financing cash flows & sunk costs shouldn’t be included Sunk cost: Expense paid previously and cannot be recovered (irrelevant) Financing cost: Interest payments (already included into discount rate) so therefore not included, as they would be double counted. Only interested in the CF’s generated by the assets of the project. Understand opportunity cost and cash flow implications Opportunity cost: CF’s an asset could generate if not used in a proposed investment. (Requires us to give up a benefit) -‐ Go at the start of cash flows E.g. market value is an opportunity cost and an incremental cash flow Using land to build on that has a market value of $7m Calculate the various tax effects (e.g. depreciation, disposal, capital gains) for calculating different cash flow estimates Company taxes: Major outflow for firms (taxes incurred paid in same yr) Operating revenue = taxable & Operating costs = tax deductible *Purchase of assets are not tax deductible at time of purchase but depreciation is allowed as a tax deduction Tax effect – CF during the life
*Net after-‐tax CF = Pre tax cash flow (1 – tc) x depreciation tax saving Higher depreciable = lower taxes payable *Depreciation tax saving = Depreciation x Tc Depreciation is not a cash expense (not including in cash flows) Charge = expense *300 = benefit from depreciation expense * Book value of an asset (WDV) = Initial cost – Accumulated Depreciation •
Tax effect on sale of asset Sale incurs tax if salvage value and book value are different If Salvage value > Book value = Taxable profit *Tax on sale (WDV – salvage value) x Tc Annual Depreciation = 100000/10 = $10 000 Book Value today = 100 000 – 5(10 000) = $50 000 5(10 000) = Accumulated Depreciation
Loss = 50 000 – 20 000 = $ 30 000 (tax saving = 30 000 x 0.3 = $9000) *If WDV > Salvage value = firm claimed too little depreciation & the government owes the company a tax refund •
Calculate NPV for a project ! Cash flows at the start: * Don’t only include purchase of plant/equipment -‐ Alterations to building/installation costs -‐ Proceeds from the sale of old machinery (replacement decision) -‐ Investment in working capital (e.g. inventory) -‐ Market value of assets owned that are to be used in the project (opportunity cost – e.g. tools to be transferred from old plant) * If a capital expenditure proposal results in a decrease in the amount of inventory then initial cash flows is reduced by the inventory change. ! Cash flows throughout life: -‐ Selling expenses for the new product -‐ Tax savings from deprecation allows on new machine
