Chapter 3 Financial Markets and Capital Budgeting
Chapter 3 Chapter 3 Financial Markets and Financial Markets and Capital Budgeting Capital Budgeting
Section 1 Capital Budgeting
Section 1 Section 1 Capital Budgeting Capital Budgeting
Financial Markets Money markets Capital markets -The primary markets the secondary market slide 2
slide 2 Financial Markets Financial Markets Money markets & Capital markets The primary markets & the secondary market
What is Capital Budgeting? The process of identifying,analyzing, and selecting investment projects whose returns (cash flows)are expected to extend beyond one year. slide 3
slide 3 What is Capital What is Capital Budgeting? Budgeting? The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year
The Capital Budgeting Process Generate investment proposals consistent with the firm's strategic objectives. Estimate after-tax incremental operating cash flows for the investment projects. Evaluate project incremental cash flows. Select projects based on a value-maximizing acceptance criterion. Reevaluate implemented investment projects continually and perform post-audits for completed projects. slide 4
slide 4 The Capital Budgeting Process The Capital Budgeting Process Generate investment proposals consistent with the firm’s strategic objectives. Estimate after-tax incremental operating cash flows for the investment projects. Evaluate project incremental cash flows. Select projects based on a value-maximizing acceptance criterion. Reevaluate implemented investment projects continually and perform post-audits for completed projects. Generate investment proposals consistent with the firm’s strategic objectives. Estimate after-tax incremental operating cash flows for the investment projects. Evaluate project incremental cash flows. Select projects based on a value-maximizing acceptance criterion. Reevaluate implemented investment projects continually and perform post-audits for completed projects
Classification of Investment Project Proposals 1.New Products or expansion of existing products 2.Replacement of existing equipment or buildings 3.Research and development 4.Exploration 5.Other (e.g.,safety or pollution related) slide 5
slide 5 Classification of Investment Classification of Investment Project Proposals Project Proposals 1. New Products or expansion of existing products 2. Replacement of existing equipment or buildings 3. Research and development 4. Exploration 5. Other (e.g., safety or pollution related)
Calculating the Incremental Cash Flows Initial cash outflow--the initial net cash investment. Interim incremental net cash flows --those net cash flows occurring after the initial cash investment but not including the final period's cash flow. Terminal-year incremental net cash flows the final period's net cash flow. slide 6
slide 6 Calculating the Incremental Cash Flows Calculating the Incremental Cash Flows Initial cash outflow Initial cash outflow -- the initial net cash investment. Interim incremental net cash flows -- those Interim incremental net cash flows net cash flows occurring after the initial cash investment but not including the final period’s cash flow. Terminal Terminal -year incremental net cash flows year incremental net cash flows -- the final period’s net cash flow
Example of an Asset Expansion Project -Basket Wonders(BW)-new basket weaving machine. -Cost $50,000 plus $20,000 for shipping and installation. -Net working capital (NWC)will rise by $5,000. -Revenues will increase by $40,000 for each of the next 4 years. -Machine to be sold (scrapped)for $10,000 at project end, -Operating costs will rise by $70,000 per four year. -BW is in the 40%tax bracket. slide 7
slide 7 Example of an Asset Expansion Project Example of an Asset Expansion Project Basket Wonders (BW) - new basket weaving machine. Cost $50,000 plus $20,000 for shipping and installation. Net working capital (NWC) will rise by $5,000. Revenues will increase by $40,000 for each of the next 4 years. Machine to be sold (scrapped) for $10,000 at project end. Operating costs will rise by $70,000 per four year. BW is in the 40% tax bracket
Initial Cash Outflow a) Cost of asset $50,000 b)+Capitalised expenditures 20,000 c)+/-In(de)creased NWC + 5,000 d)-Net proceeds from sale of 0 old asset (if replacement) e)+/-Taxes (savings)due to d) 0 f Initial cash outflow $75,000 slide 8
slide 8 Initial Cash Outflow Initial Cash Outflow a) Cost of asset $ 50,000 b) + Capitalised expenditures + 20,000 c) +/- In(de)creased NWC + 5,000 d) - Net proceeds from sale of old asset (if replacement) e) +/- Taxes (savings) due to d) 0 0 f) Initial cash outflow $ 75,000
Incremental Cash Flows Year 1 Year 2 Year 3 Year 4. a)net A in oper.revenue $40,000$40,000 $40,000 $40,000. b)+/-net A in tax deprec. -23,331-31115 -1036 7-5,187. C) =net△in income bf tax $16669$8,885$29,633$34813. d)+/-net△in taxes -6,668 -3,554 -11,853 -13,925. e)+/-net A in inc.after tax $10,001$5,331$17780$20,888. f)+/net A in tax deprec.charges 23,331 31,115 10367 5,187. g)Incremental net cashflow $33,332 $36,446 $28,147 $26,075. where△=change. slide 9
slide 9 Incremental Cash Flows Incremental Cash Flows Year 1 Year 2 Year 3 Year 4. a) net Δ in oper. revenue $40,000 $40,000 $40,000 $40,000. b) +/- net Δ in tax deprec. -23,331 -31,115 -10,367 -5,187. c) = net Δ in income bf tax $16,669 $ 8,885 $29,633 $34,813. d) +/- net Δ in taxes -6,668 -3,554 -11,853 -13,925. e) +/- net Δ in inc. after tax $10,001 $ 5,331 $17,780 $20,888. f) +/- net Δ in tax deprec. charges 23,331 31,115 10,367 5,187. g) Incremental net cashflow $33,332 $36,446 $28,147 $26,075. $33,332 $36,446 $28,147 $26,075. where Δ = change
