Chapter 10: Cash Flows and Other Topics in Capital budgeting o 2002. Prentice Hall. Inc
Chapter 10: Cash Flows and Other Topics in Capital Budgeting © 2002, Prentice Hall, Inc
Capital Budgeting: the process of planning for purchases of long-term assets. example Our firm must decide whether to purchase a new plastic molding machine for $127,000 how do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment The relevant project information follows:
Capital Budgeting: the process of planning for purchases of long-term assets. • example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? • Will the machine be profitable? • Will our firm earn a high rate of return on the investment? • The relevant project information follows:
The cost of the new machine is S127,000. Installation will cost S20.000 s4, 000 in net working capital will be needed at the time of installation The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase Simplified straight line depreciation is used. Class life is 5 years, and the firm is planning to keep the project for 5 years. Salvage value at the end of year 5 will be $50,000. 14% cost of capital; 34% marginal tax rate
• The cost of the new machine is $127,000. • Installation will cost $20,000. • $4,000 in net working capital will be needed at the time of installation. • The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. • Simplified straight line depreciation is used. • Class life is 5 years, and the firm is planning to keep the project for 5 years. • Salvage value at the end of year 5 will be $50,000. • 14% cost of capital; 34% marginal tax rate
Capital Budgeting Steps 1)Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project Initial outlay Differential cash flows over the life of the project (also referred to as annual cash flows). Terminal cash flows
Capital Budgeting Steps 1) Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project. • Initial outlay • Differential Cash Flows over the life of the project (also referred to as annual cash flows). • Terminal Cash Flows
Capital Budgeting Steps 1)Evaluate Cash Flows 0123456
Capital Budgeting Steps 1) Evaluate Cash Flows 0 1 2 3 4 5 6 . . . n
Capital Budgeting Steps 1)Evaluate Cash Flows Initial outlay 0123456
Capital Budgeting Steps 1) Evaluate Cash Flows 0 1 2 3 4 5 6 . . . n Initial outlay
Capital Budgeting Steps 1)Evaluate Cash Flows Initial outlay 0123456 Annual cash flows
Capital Budgeting Steps 1) Evaluate Cash Flows 0 1 2 3 4 5 6 . . . n Annual Cash Flows Initial outlay
Capital Budgeting Steps 1)Evaluate Cash Flows Initial Terminal outlay Cash flow 0123456 Annual cash flows
Capital Budgeting Steps 1) Evaluate Cash Flows 0 1 2 3 4 5 6 . . . n Terminal Cash flow Annual Cash Flows Initial outlay
Capital Budgeting Steps 2) Evaluate the risk of the project Well get to this in the next chapter. For now. we'l assume that the risk of the project is the same as the risk of the overall firm If we do this. we can use the firm's cost of capital as the discount rate for capital investment proiects
2) Evaluate the risk of the project. • We’ll get to this in the next chapter. • For now, we’ll assume that the risk of the project is the same as the risk of the overall firm. • If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects. Capital Budgeting Steps
Capital Budgeting Steps 3)Accept or Reject the Project
3) Accept or Reject the Project. Capital Budgeting Steps