# Reading 22 Capital Budgeting Part 2

Pages: 19 (1354 words) Published: December 15, 2014
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CFA Level II
Corporate Finance
CFA Lecturer: 廖靖雯

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Capital Budgeting

Incremental Cash Flow

We classify incremental cash flows for capital projects as:
(1) initial investment outlay
(2) operating cash flow over the project's life
(3) terminal-year cash flow

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(1) Initial investment outlay
Initial investment outlay is the up-front costs associated with the project. outlay = FCInv + NWCInv
FCInv: shipping and installation
NWCInv: investment in net working capital
NWCInv = ∆non-cash current assets - ∆non-debt current liabilities = ∆NWC

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(2) After-tax operating cash flows
After-tax operating cash flows (CF) are the incremental cash inflows over the capital asset's economic life.
CF = (S – C - D)(1 - T) + D
= (S -C)(l -T) + (TD)
where:
S =sales
C = cash operating costs
D = depreciation expense
T = marginal tax rate

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(3) Terminal year after-tax non-operating cash flows

At the end of the asset's life, there are certain cash inflows that occur. TNOCF = SalT + NWCinv - T(SalT - BT)
where:
SalT = pre-tax cash proceeds from sale of fixed capital
BT = book value of the fixed capital sold

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Expansion Project Analysis

An expansion project is an investment in a new asset to increase both the size and earnings of a business.

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Example
Banana Tech, Inc. would like to set up a new plant. Currently, Banana has an option to buy an existing building at a cost of \$25,000. Necessary equipment for the plant will cost \$18,000, including installation costs. The equipment falls into a MACRS 5-year class. The building falls into a MACRS 39-year class. The project would also require an initial investment of \$10,000 in net working capital. The initial working capital investment will be made at the time of the purchase of the building and equipment.

The project's estimated economic life is four years. At the end of that time, the building is expected to have a market value of\$16,000 and a book value of\$22,036, whereas the equipment is expected to have a market value of \$4,500 and a book value of \$2,690.

Annual sales will be \$90,000. The production department has estimated that variable manufacturing costs will total 60% of sales and that fixed overhead costs, excluding depreciation, will be \$10,000 a year [costs: (0.60)90,000 + 10,000 = 64,000]. Depreciation expense will be determined for the year in accordance with the MACRS rate.

Banana's marginal federal-plus-state tax rate is 40%; its cost of capital is 12%; and, for capital budgeting purposes, the company's policy is to assume that operating cash flows occur at the end of each year. The plant will begin operations immediately after the investment is made, and the first operating cash flows will occur exactly one year later.

Under MACRS, the pre-tax depreciation for the building and equipment is: Year 1 = \$3,925; Year 2 = \$6,410; Year 3 = \$4,070; Year 4 = \$2,810 Compute the initial investment outlay, operating cash flow over the project's life, and the terminal-year cash flows for Banana's expansion project. Then determine whether the project should be accepted using NPV analysis.

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(1) Initial outlay = price of building + price of equipment + NWCinv = \$25,000 + \$18,000 + \$10,000 = \$53,000
(2) Operating cash flows:
CF = (S - C)(1 - T) + DT
CF 1 = [(\$90,000 - 64,000)(0.6)] + (3,925)(0.4) = \$17,170
CF 2 = 15,600 + (6,410)(0.4) = \$18,164
CF 3 = 15,600 + (4,070)(0.4) = \$17,228
CF 4 = 15,600 + (2,810)(0.4) = \$16,724
(3) Terminal year...