Capital Budgeting

Summaries

Capital Project – where cash flow is over 1 year period

Capital Projects:

1)      Replacement project to maintain the current business

2)      Replacement project for cost reduction

3)      Expansion Project

4)      New Product/Market

5)      Mandatory Project

Capital Budgeting:

1)      Decisions made based on incremental cash flow

a.      Sunk cost

b.      Externalities (-ve: cannibalization, +ve)

2)      Opportunity cost has to be considered

3)      Tax has to be considered

4)      Financial cost as discount rate

Modified Accelerated Cost Recovery System (MACRS)

-          assets divided into different classes and use table lookup

-          assuming started service in the middle of the year (so 3-year asset has 4 years life)

-          All shipping/installation costs are added to the purchase price

Expansion project:

1. Outlay = Net-working-capital change + initial investment
2. Net-working-capital change = non-cash short-term asset – non-debt short-term liability
3. CF each year = (Sale – Cost) * (1-tax) + Depreciation * tax)
4. Terminal year = Net-working-capital change + sale of equipment – tax * (sale value – book value)***

Replacement project:

1. Outlay = Net-working capital change + initial investment – sale of old machine + tax * (sale value – book value)
2. Delta CF each year  = Delta (Sale- Cost)*(1-tax) + Delta D * tax
3. Terminal year  = Net-working-capital change + sale of equipment – tax *(sale value –book value)***

*** Should use the depreciated value not the so called estimated salvage value to calculate the tax benefit

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