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,Study unit 1 – Chapter 11 – Capital budgeting cash flows
11.1 Relevant cash flows
To evaluate capital expenditure alternatives, the firm must determine the relevant cash flows.
Relevant cash flows: incremental cash outflow (investment and resulting subsequent inflows associated
with proposed capital expenditure
Incremental cash flows: additional cash flows – outflows or inflows- expected to result from proposed
capital expenditure
Cash flows directly influence the firm’s ability to pay bills and purchase assets.
Major cash flow components
Cash flows of any project having conventional pattern can include :
• Initial investment: relevant cash outflow for a proposed project at time zero
• Operating cash inflows: incremental after tax cash inflows resulting from implementation of
project during its life
• Terminal cash flows: after—tax non-operating cash flow occurring in final year of project its
usually attributable to liquidation of project
Expansion versus replacement decisions
Developing relevant cash flow estimated is most straightforward in case of expansion decisions. Initial,
operating and terminal cash flows are the after-tax cash outflow and inflows associated with proposed
capital expenditure
Replacement decision; firm must identify the incremental cash outflows and inflows that would result
from proposed replacement
- Initial investment in case of replacement is difference between the initial investment needed to
acquire new asset and any after-tax cash inflows expected from liquidation of old asset
- Operating cash inflows difference between operating cash inflows from new asset from old asset
- Terminal cash flows is difference between after-tax cash flows expected upon termination of new
and old asset
All capital budgeting decisions can be viewed as replacement decisions
Expansion decisions are merely replacement decisions in which all cash flows from old asset are zero Pg
426 textbook
Sunk costs and opportunity costs
,Sunk costs: cash outflows that have already been made and therefore have no effect on cash flows
relevant to current decision. Unavoidable and cannot be recovered, should not be included in projects
incremental cash flows.
Opportunity costs: cash flows that could be realized from best alternative use of an owned asset, represent
cash flows that will not be released as a result of employing that assist in proposed project. Should be
included in cash outflows when determining projecting incremental cash flows
International capital budgeting and long-term investment
Several additional factors must be addressed in evaluating foreign investment opportunities, international
differs from domestic in that:
Cash outflows and inflows occurring in foreign currency
Foreign investment entail potentially significant political risk
Face both long-term and short0term currency risk related to both invested capital and cash flows
resulting from it.
o Long-term risk can be minimized by financing the foreign investment at least partly in
local capital markets
o Local currency cash flows can be protected by using special securities and strategies
Political risk can be minimized by using both operating and financial strategies
Foreign direct investment; transfer of capital as well as managerial and technical assets to a foreign
country
11.2 Finding the initial investment
Initial investment refers to relevant cash outflows to be considered when evaluating prospective capital
expenditure, initial investment occurs at time zero – time at which expenditure is made.
Initial investment: cash inflows occurring at time zero minus cash out flows occurring at time zero
Cash flows that must be considered when determining the initial investment associated with capital
expenditure:
Installed costs of new asset
After-tax proceeds from sale of old asset
Change in net working capital
If there are no installation costs the firm is not replacing an existing asset, cost of new asset adjusted for
any change in networking capital is equal to initial investment
Installed cost of new asset
Add cost of new asset to installation costs.
, Cost of new asset: net outflow that its acquisition requires
Installation cost: any added costs that are necessary to place asset into operation
• SARS requires firm to add installation costs to purchase price of asset to determine depreciable
value
Installed cost of new asset: calculated by adding cost of new asset to installation costs, equals depreciable
value
After-tax proceeds from sale of old asset
• After-tax proceeds from sale of old asset decrease firms initial investment in new asset.
• Tax on sale of old asset depends on relationship between sale price and tax value on existing
government tax rules
Tax value: strict accounting value of an asst calculated by subtracting its accumulated wear and tear from
its installed cost
Tax value = installed cost of asset – accumulated wear and tear
Basic tax rules
3 possible tax situations:
Asset can be sold for:
- More than tax value
- Its tax value
- Less than its tax value
PG 430 + 431
Change in net working capital
Net working capital: amount by which a firms current assets exceed its current liabilities.
• Changes in net working capital often accompany capital expenditure decisions
• Firm acquires new machinery to expand its level of operations it will experience increase in
levels of cash, trade receivables, inventories, trade and other receivables
• Increases result from need for more cash to support expanded operations, more trade receivables
and inventories to support increased sales
• Increases in cash trade receivables and inventories are outflows of cash
• Increase in trade and other payables and accruals are inflows of cash
Change in net working capital: difference between change in current assets and change in current
liabilities
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