BUS601: Financial Management

Making capital-budgeting decisions involves analyzing cash inflows and outflows. This section shows you how to calculate the benefits and costs used in capital-budgeting decisions. Because money has a time value, these benefits and costs are adjusted for time under the last two methods covered in the chapter.

Money received today is worth more than the same amount of money received at a future date, such as a year from now. This principle is known as the time value of money. Money has time value because of investment opportunities, not because of inflation. For example, USD 100 today is worth more than USD 100 to be received one year from today because the USD 100 received today, once invested, grows to some amount greater than USD 100 in one year. Future value and present value concepts are extremely important in assessing the desirability of long-term investments (capital budgeting). If you need to review these concepts, refer back to the appendix to Chapter 15, which covers these concepts.

The net cash inflow (as used in capital budgeting) is the net cash benefit expected from a project in a period.

The net cash inflow is the difference between the periodic cash inflows and the periodic cash outflows for a proposed project.

Asset acquisition

Assume, for example, that a company is considering the purchase of new equipment for USD 120,000. The equipment is expected (1) to have a useful life of 15 years and no salvage value, and (2) to 979 produce cash inflows (revenue) of USD 75,000 per year and cash outflows (costs) of USD 50,000 per year. Ignoring depreciation and taxes, the annual net cash inflow is computed as follows:

Depreciation and taxes

The computation of the net cash inflow usually includes the effects of depreciation and taxes. Although depreciation does not involve a cash outflow, it is deductible in arriving at federal taxable income. Thus, depreciation reduces the amount of cash outflow for federal income taxes. This reduction is a tax savings made possible by a depreciation tax shield. A tax shield is the total amount by which taxable income is reduced due to the deductibility of an item. For example, if depreciation is USD 8,000, the tax shield is USD 8,000. To simplify the illustration, we assume the use of the straight-line depreciation for tax purposes throughout the chapter. Straight-line depreciation can be elected for tax purposes, even under the new tax law.

The tax shield results in a tax savings. The amount of the tax savings can be found by multiplying the tax rate by the amount of the depreciation tax shield. The formula is:

Tax rate x Depreciation tax shield=Tax savings

Using the data in the previous example and assuming straight-line depreciation of USD 8,000 per year and a 40 percent tax rate, the amount of the tax savings is USD 3,200 (40 percent x USD 8,000 depreciation tax shield). Now, considering taxes and depreciation, we compute the annual net cash inflow from the USD 120,000 of equipment as follows:

If there were no depreciation tax shield, federal income tax expense would have been USD 10,000, or (USD 25,000 x 40 percent), and the net after-tax cash inflow from the investment would have been USD 15,000, found by (USD 25,000 - USD 10,000), or [USD 25,000 x (1 - 40 percent)].

The depreciation tax shield, however, reduces federal income tax expense by USD 3,200, or (USD 8,000 x 40 percent), and increases the investment's after-tax net cash inflow by the same amount. Therefore, the following formula also can be used to determine the after-tax net cash inflow from an investment:

Net cash inflow after taxes = [Net cash inflow before taxes x (1 - Tax rate)] + [Depreciation expense X Tax rate]

                                                              v                                                                                                     v

                    Net cash inflow after taxes (ignoring depreciation)           Tax savings attributable To depreciation tax shield

= (USD25,000x( 1 -.4))+( USD 8,000 X.4 )=USD 18,200

 Asset replacement Sometimes a company must decide whether or not it should replace existing plant assets. Such replacement decisions often occur when faster and more efficient machinery and equipment appear on the market.

The computation of the net cash inflow is more complex for a replacement decision than for an acquisition decision because cash inflows and outflows for two items (the asset being replaced and the new asset) must be considered. To illustrate, assume that a company operates two machines purchased four years ago at a cost of USD 18,000 each. The estimated useful life of each machine is 12 years (with no salvage value). Each machine will produce 40,000 units of product per year. The annual cash operating expenses (labor, repairs, etc.) for the two machines together total USD 14,000. After the old machines have been used for four years, a new machine becomes available. The new machine can be acquired for USD 28,000 and has an estimated useful life of eight years (with no salvage value). The new machine produces 60,000 units annually and entails annual cash operating expenses of USD 10,000. The USD 4,000 reduction in operating expenses (USD 14,000 - USD 10,000) is a USD 4,000 increase in net cash inflow (savings) before taxes.

The firm pays USD 28,000 in the first year to acquire the new machine. In addition to this initial outlay, the annual net cash inflow from replacement is computed as follows:

Net cash inflow after taxes= (Annual net cash inflows(savings) before taxes×(1 – tax rate)) + Additional annual depreciation expense × Tax rate

In formula format, the calculation is:

Net cash inflow after taxes = ( USD 4,000x ( 1 - .4) )+( USD 500 x.4) = USD 2,600

Notice that these figures concentrated only on the differences in costs for each of the two alternatives. Two other items also are relevant to the decision. First, the purchase of the new machine creates a USD 28,000 cash outflow immediately after acquisition. Second, the two old machines can probably be sold, and the selling price or salvage value of the old machines creates a cash inflow in the period of disposal. Also, the previous example used straight-line depreciation. If the modified Accelerated Cost Recovery System (modified ACRS) had been used, the tax shield would have been larger in the early years and smaller in the later years of the asset's life.

Out-of-pocket and sunk costs

A distinction between out-of-pocket costs and sunk costs needs to be made for capital budgeting decisions. An out-of-pocket cost is a cost requiring a future outlay of resources, usually cash. Out-of-pocket costs can be avoided or changed in amount. Future labor and repair costs are examples of out-of- pocket costs.

Sunk costs are costs already incurred. Nothing can be done about sunk costs at the present time; they cannot be avoided or changed in amount. The price paid for a machine becomes a sunk cost the minute the purchase has been made (before that moment it was an out-of-pocket cost). The amount of that past outlay cannot be changed, regardless of whether the machine is scrapped or used. Thus, depreciation is a sunk cost because it represents a past cash outlay. Depletion and amortization of assets, such as ore deposits and patents, are also sunk costs.

A sunk cost is a past cost, while an out-of-pocket cost is a future cost. Only the out-of-pocket costs (the future cash outlays) are relevant to capital budgeting decisions. Sunk costs are not relevant, except for any effect they have on the cash outflow for taxes.

Initial cost and salvage value

Any cash outflows necessary to acquire an asset and place it in a position and condition for its intended use are part of the initial cost of the asset. If an investment has a salvage value, that value is a cash inflow in the year of the asset's disposal.

The cost of capital

The cost of capital is important in project selection. Certainly, any acceptable proposal should offer a return that exceeds the cost of the funds used to finance it. Cost of capital, usually expressed as a rate, is the cost of all sources of capital (debt and equity) employed by a company. For convenience, most current liabilities, such as accounts payable and federal income taxes payable, are treated as being without cost. Every other item on the right (equity) side of the balance sheet has a cost. The subject of determining the cost of capital is a controversial topic in the literature of accounting and finance and is not discussed here. We give the assumed rates for the cost of capital in this book. Next, we describe several techniques for deciding whether to invest in capital projects.