** It was pointed out** in the valuation of corporate securities overview that the value of an asset, whether financial or real, depends on the discounted value of cash flows over a relevant time horizon.

Capital budgeting deals with the valuation of real assets. Cash outflows at time 0 and net cash flows over the specified time horizon are taken into account in capital budgeting.

## Summary of Capital Budgeting

Capital Budgeting is an extremely important aspect of a company’s financial management. Although capital assets usually comprise a smaller percentage of a company’s total assets than do current assets, capital assets are long-term. Therefore, a company that makes a mistake in its capital budgeting process has to live with that mistake for a long period of time.

#### Capital Expenditure

An expenditure that is expected to benefit a company for a period of time longer than a year; usually much longer.

#### Capital Budgeting

Total process of generating, evaluating, selecting and following up on capital expenditures.

#### Motivations for Investments/Expenditures:

- Replacement
- Expansion
- Modernization
- Strategic

## Valuation

While working with capital budgeting, one is actually performing a valuation.

**In Valuation:**

- In valuation, cash flows are identified and discounted down to present value.

In capital budgeting just as in valuation, the emphasis is on cash flows—those cash flows at acquisition and every year thereafter for economic life of the project.

Remember, in capital budgeting what is important is cash flow, not profits. The cash flows at acquisition are called *net investment* 3and those every year after are termed *net cash flows*.

## Net Investment

Net Investment = Cost of New Project

+ Installation Costs

− Proceeds from Sale or Disposal of Assets

± Taxes on Sale of Assets

The amount of taxes and the way proceeds are taxed depends directly on the relationship between proceeds, the initial purchase price, and the book value of the item being replaced.

### Example 1

Assume a company buys a new tooling machine for $1,000,000, installation costs net of taxes are $100,000, an existing asset has a book value of $200,000, and the company is in the 30% tax bracket.

**Sale of Asset for its Book Value:**

If an asset is sold for its book value, there is no tax effect.

Assume the company sells the existing asset for $200,000.

Cost | $1,000,000 |

Installation | + $100,000 |

Proceeds | − $200,000 |

Taxes | $0 |

Net Investment | $900,000 |

Book value and market value are the same, so there is no tax effect.

### Example 2

Assume again that a company buys a new tooling machine for $1,000,000, installation costs net of taxes are $100,000, an existing asset has a book value of $200,000, and the company is in the 30% tax bracket.

**Sale of Asset for Less than Book Value:**

If a company disposes of an asset for less than its book value, it will experience a loss.

This loss may result in tax savings.

Assume the company sells the existing asset for $75,000.

Cost | $1,000,000 |

Installation | + $100,000 |

Proceeds | − $75,000 |

Taxes | − $37,500 |

Net Investment | $987,500 |

### Example 3

Assume once more that a company buys a new tooling machine for $1,000,000, installation costs net of taxes are $100,000, an existing asset has a book value of $200,000, and the company is in the 30% tax bracket.

**Sale of Asset for More than its Book Value:**

This would result in additional taxes, since depreciation would be recaptured.

Assume the company sells the existing asset for $225,000.

Cost | $1,000,000 |

Installation | + $100,000 |

Proceeds | − $225,000 |

Taxes | − $7,500 |

Net Investment | $882,500 |

## Net Cash Flows

Net Cash Flows are the cash flows every year after a project is adopted.

Δ Projected Earnings Before Taxes and Depreciation

− Δ Depreciation

= Change in Taxable Earnings (1−Tax Rate)

= Earnings After Taxes

+ Δ Depreciation

= Net Cash Flows

Δ EBTD

− Δ DEPR

= Δ EBT(1−t)

= EAT

+ Δ DEPR

= NCF

– or –

Δ EBTD − Δ DEPR = Δ EBT(1−t) = EAT + Δ DEPR = NCFProjected change in earnings before taxes and depreciation arises from costs savings or added returns to the company.

### Example 1

Your company is evaluating the purchase of a new project with a depreciable base of $100,000, expected economic life of 4 years and change in earnings before taxes and depreciation of $45,000 year 1, $20,000 year 2, $25,000 year 3 and $35,000 year 4. Assume straightline depreciation and a 20% tax rate.

Yr | EBTD | − | DEPR | = | EBT(1−t) | = | EAT | + | DEPR | = | NCF |
---|---|---|---|---|---|---|---|---|---|---|---|

1 | $45,000 | − | $25,000 | = | $20,000(.8) | = | $16,000 | + | $25,000 | = | $41,000 |

2 | $20,000 | − | $25,000 | = | −$5,000(.8) | = | −$4,000 | + | $25,000 | = | $21,000 |

3 | $25,000 | − | $25,000 | = | $0(.8) | = | $0 | + | $25,000 | = | $25,000 |

4 | $35,000 | − | $25,000 | = | $10,000(.8) | = | $8,000 | + | $25,000 | = | $33,000 |

The depreciation in this example is $25,000 per year. ($100,000 ÷ 4)

### Example 2

You have the following information available: Company is in 30% tax rate.

**Estimated Earnings**

Without New Project | With New Project | |
---|---|---|

1 | $100,000 | $175,000 |

2 | $120,000 | $185,000 |

3 | $140,000 | $150,000 |

**Depreciation**

Without New Project | With New Project | |
---|---|---|

1 | $10,000 | $50,000 |

2 | $10,000 | $60,000 |

3 | $10,000 | $70,000 |

In this case, you have to figure the differences in projected earnings and depreciation with and without the new project. What you’re interested in is the incremental effect of the new project.

**Estimated Earnings**

Without New Project | With New Project | Diff | |
---|---|---|---|

1 | $100,000 | $175,000 | $75,000 |

2 | $120,000 | $185,000 | $65,000 |

3 | $140,000 | $150,000 | $10,000 |

**Depreciation**

Without New Project | With New Project | Diff | |
---|---|---|---|

1 | $10,000 | $50,000 | $40,000 |

2 | $10,000 | $60,000 | $50,000 |

3 | $10,000 | $70,000 | $60,000 |

NOTE: There’s probably no depreciation technique where we could get a depreciation schedule like this. This is just for purposes of illustration.

Yr | EBTD | − | DEPR | = | EBT(1−t) | = | EAT | + | DEPR | = | NCF |
---|---|---|---|---|---|---|---|---|---|---|---|

1 | $75,000 | − | $40,000 | = | $35,000(.7) | = | $24,500 | + | $40,000 | = | $64,500 |

2 | $65,000 | − | $50,000 | = | $15,000(.7) | = | $10,500 | + | $50,000 | = | $60,500 |

3 | $10,000 | − | $60,000 | = | −$50,000(.7) | = | −$35,000 | + | $60,000 | = | $25,000 |

### Example 3

Your company is thinking about investing in a new project with a depreciable base of $160,000 and an expected economic life of 4 years. Use straight line depreciation. The project will eliminate the need for two workers making $35,000 per year each. Fringes and overtime for each of the employees are $4000 per year. Waste and defects, currently $50,000 per year, will be cut in half. Maintenance expenses will go up by $1000 per year, and insurance costs will go up by $2000 per year. The tax rate is 15%.

Here you have a word problem. Perhaps the most efficient thing to do would be to estimate what the company would be doing if they don’t invest in the new project, what they would be doing if they do invest in the new project, and then figure the differences.

Without New Project | With New Project | Difference | |
---|---|---|---|

Salaries | $70,000 | $0 | |

Fringes & OT | $8,000 | $0 | |

Waste | $50,000 | $25,000 | |

Maintenance | ? | + $1,000 | |

Insurance | ? | + $2,000 | |

Total | $128,000 | $28,000 | $100,000 |

Years | EBTD | − | DEPR | = | EBT(1−t) | = | EAT | + | DEPR | = | NCF |
---|---|---|---|---|---|---|---|---|---|---|---|

1-4 | $100,000 | − | $40,000 | = | $60,000(.85) | = | $51,000 | + | $40,000 | = | $91,000 |

## Capital Budgeting Techniques

There are a number of capital budgeting techniques available to an analyst. For our purposes, we will only review *net present value* and *internal rate of return*.

### Net Present Value

The Net Present Value technique involves discounting net cash flows for a project, then subtracting net investment from the discounted net cash flows. The result is called the Net Present Value(NPV). If the net present value is positive, adopting the project would add to the value of the company. Whether the company chooses to do that will depend on their selection strategies. If they pick all projects that add to the value of the company, they would choose all projects with positive net present values even if that value is just $1. On the other hand, if they have limited resources, they will rank the projects and pick those with the highest NPV’s.

The discount rate used most frequently is the company’s cost of capital.

#### Example

What would the net present value for a project with a net investment of $40,000 and the following net cash flows be if the company’s cost of capital is 5%? NCFs for year one is $25,000, for year two is $36,000 and for year three is $5000.

Yr | Net Cash Flows | × | PVIF@5% | Discounted Cash Flows |
---|---|---|---|---|

1 | $25,000 | × | .952 | $23,800 |

2 | $36,000 | × | .907 | $32,652 |

3 | $5,000 | × | .864 | $4,320 |

Total Discounted Cash Flows Discounted at 5% | $60,772 | |||

Less: Net Investment | − $40,000 | |||

Net Present Value | $20,772 |

### Internal Rate of Return

The internal rate of return (IRR) on a project is the rate of return where the cash inflows (net cash flows) equals the cash outflows (net investment.) The easiest way to find IRR is to use a financial calculator or spreadsheet program.

An example of a project with a net investment of $10,000, net cash flows of $5,000, $4,000, $3,000, $2,000, $1,000 for years 1 through 5 returns an IRR of 20.27%.

To determine this using Microsoft Excel 2007, enter the numbers in our example into Column A starting at Row 1 with the net investment shown as a negative number.

The column of data appears:

A | B | |
---|---|---|

1 | -10000 | |

2 | 5000 | |

3 | 4000 | |

4 | 3000 | |

5 | 2000 | |

6 | 1000 | =IRR(A1:A6) |

7 |

Once you have entered the column of numbers as detailed, position the cursor in an adjacent, empty cell and insert the IRR function, which is: `=IRR()`

. Within the function, you need to reference the cells that contain the numbers for which you want to calculate IRR; in this case, cells A1 through A6. So, the final function will look like: `=IRR(A1:A6)`

. Once you have this, press [ENTER] and the result of the function formula will be 20%.

In our example above, we calculate the IRR to two decimal places. To do this in Excel, select the cell containing the IRR function formula and click the small arrow on the lower right of the **Number** group on the **Home** tab of the Ribbon. The **Format Cells** dialog box will appear. The **Number** tab should be selected with the **Percentage** category selected. On the right you will notice a box allowing you to change the decimal places. In this box, enter **2** and click OK. The IRR should now be 20.27%.

This overview was developed by Dr. Sharon Garrison.

No adaptation of its content is permitted without permission.