Module 2.

3 Capital Budgeting, Cash Flow

Principles, & Risk
This module then completes Chapter 12, which examines risk and refinements in capital
budgeting. Up until now, we have assumed that all projects' cash flows have the same level of
risk, which suggests that the acceptance of projects leaves the overall risk of the firm unchanged.
However, these assumptions do not hold in reality because projects do not have equal risk. In
Chapter 12, we relax the assumption of equal risk and focus on how managers evaluate projects
with different risk levels. The techniques that we will look at in Chapter 12 will focus either
on adjusting the project cash flows, or adjusting the rate at which the cash flows are discounted.

Chapter 11 introduces the important topic of capital budgeting cash flows. To be able to
evaluate long-term investment projects using the capital budgeting techniques introduced in
the last chapter, managers must first estimate the future cash flows associated with each of the
investment opportunities.

Finding the Initial Investment

Table 11.1 presents a format for determining the initial investment. Cash outflows are shown
as positive amounts and inflows as negative. An alternative format is presented in the table
below with cash outflows recorded as negatives and cash inflows shown as positive values
(which is the opposite of Table 11.1).

An Alternative Initial Investment Format

After-tax proceeds from sale of old asset:
Proceeds from sale of old asset xx,xxx
+/- Taxes on sale of old asset x,xxx xx,xxx
Less installed cost of new asset:
Cost of new asset (xxx,xxx)
+ Installation costs (xx,xxx) (xxx,xxx)
+/- Change in net working Capital (x,xxx)

Equals Initial Investment ($xxx,xxx)

The alternative format above allows us to ask ourselves whether any particular cash flow is
increasing (cash inflow) or decreasing (cash outflow) a firm’s cash balances. Therefore if it is
a cash outflow (e.g. taxes to pay on the old machine) then we can show the sign as negative. If
it is a cash inflow (e.g. sale of old machine, or tax savings on the sale of the old machine) then
it is shown as positive. The above format is consistent with the way the operating cash flows
and terminal cash flows are presented at the end of Chapter 11.

You can use either the text book format or the alternative format above. Therefore, use the
format that you feel the most comfortable with.

Note, Chapter 11 includes a discussion of the US tax treatment for the sale of assets. You are
not responsible to learn the US tax system, but rather, should learn the New Zealand tax
treatment. There are two major differences between the US and New Zealand tax treatments.
The first is the tax treatment for the sale of assets. The Zutter and Smart textbook assumes that

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capital gains are taxable, which is not currently the case in New Zealand. The second is the tax
treatment of depreciation of assets for tax purposes. Chapter 11 assumes the use of the modified
accelerated cost recovery system (MACRS) using specified recovery periods. This does NOT
apply in New Zealand. Before reading Section 11.2, you may wish to refer to the points below
concerning depreciation and taxes.

Depreciation
New Zealand businesses have a choice of using either a straight-line rate of depreciation or an
accelerated rate called the diminishing value method. Most firms prefer the diminishing value
method because it reduces income tax expense in the early years of asset ownership.

If a straight-line rate is applied, then the depreciation allowance is calculated as a percentage

of the cost of the asset. However, using a diminishing value method, the allowance is calculated
as a percentage of the book value9 of the asset. The particular percentage rate allowed depends
on the nature of the asset, and the industry in which it is used. Since businesses normally wish
to claim the maximum allowable depreciation expense in any year, the depreciable value is the
total cost (including installation costs). Therefore, no adjustment is made for the expected
salvage value of the asset.

The Inland Revenue Department (IRD) publishes several booklets on depreciation (IR260 and
IR265) which explain how the IRD expects businesses to determine depreciation and contains
the depreciation rates allowed for assets. These booklets can be downloaded from the IRD
website http://www.ird.govt.nz.

Acquiring an Asset
When an asset is acquired, depreciation can be claimed for each month or part month that the
asset was owned. For example, if a firm has a 31 March year-end, then a $5,000 asset acquired
on 29 January can be depreciated at the allowable rate multiplied by 3/12ths of a year:

3 months
$5,000  12.5%   $156.25
12 months

Even though the asset was owned for only 3 days in the month of January, depreciation can be
claimed for the entire month.

Basic Tax Rules

Disposing of an Asset
When a depreciable asset is sold, any loss on sale may be written off as an expense, while a
profit on sale is included in income for the year. Furthermore, if the useful life of an asset has
expired with a salvage value of zero, then the remaining undepreciated cost can be expensed
in the final year of life.

9
The Income Tax Act’s depreciation regime uses the term “adjusted tax value” which is defined as the “base
price minus aggregate deductions” or simply the original cost less accumulated depreciation. For
consistency with the text book we will refer to the adjusted tax value as book value. However, one must
remember that a company can use different depreciation rates than those allowed by the IRD when reporting
to shareholders. As we are trying to determine the after-tax cost of incremental cash flows we must use the
depreciation rates allowable by the IRD.

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Capital Gains
When an asset is sold for more than its initial purchase price, a capital gain results, being the
amount by which the sales price exceeds the initial purchase price. In New Zealand, capital
gains are not normally subject to tax. A notable exception is the recent imposition of an income
tax on realised gains on residential property purchased and sold within a two-year period. This
does not apply to family homes. In this course we will assume a 0% rate of capital gains tax.

Example: The sale of an asset for more than its initial price
The Hudson Industries Example 11.3 (see pages 527-528) has been reworked to demonstrate
the New Zealand treatment of capital gains. Capital gains only arise when the sale price is more
than the asset’s initial purchase price.

Sales price 110,000

Initial purchase price 100,000
Non-taxable capital gain $ 10,000

Initial purchase price 100,000

Book value, end of Year Two 60,000
Recovered depreciation $40,000

The depreciation claimed in Year One and Two ($40,000) must be included in ordinary income
in the year of sale (end of Year Two10). In effect the company has claimed $40,000 too much
depreciation and the IRD now requires it to be added back into year two’s taxable income.
However, the difference between the initial purchase price and the sales price is not subject to
tax, as it represents a non-taxable capital gain.

Using the example’s tax rate of 21%, the taxes on the recovered depreciation of $40,000 are
calculated as follows:
Recovered depreciation 40,000
Tax rate x 21%
Total tax, Year Two $8,400

The remaining Hudson examples which include an asset being sold for more than book value
but less than its initial purchase price, an asset sold for book value and also when an asset is
sold for less than book value, correctly demonstrate the effective tax impact for New Zealand
income tax purposes. In New Zealand the loss on sale of depreciable assets may be used to
offset ordinary operating income. If the asset is not depreciable or not used in the business, the
loss cannot be used for tax purposes.

10
In practice, depreciation cannot be claimed in the year of sale in New Zealand. However, if we assume
that an asset is sold immediately on the first day of the year following the asset’s sale then the capital
budgeting methodology presented in the text can be followed directly.

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 Checklist of Depreciation & Tax Treatments

 You should assume that the company tax rate is 28% unless specifically told
otherwise in the question.
 In general there is no capital gains tax in New Zealand, therefore use a rate of zero
percent in the assignments and exams.
 Any installation and other incidental costs associated with buying an asset must
be included in the initial cost of that asset. The total cost can then be depreciated.
 For simplicity assume that any taxes arising from the sale of an asset are to be
calculated as part of the initial investment or terminal cash flow11.
 When calculating depreciation firms usually claim the maximum allowed by the
IRD in any given year, as this reduces their tax bill. Therefore, depreciation is
calculated on the asset’s initial purchase price (including installation costs) and
no adjustment is made for the asset’s expected salvage value.

Treatment of Net Working Capital

It is often poorly understood why a change in net working capital is included in the calculation
of initial and terminal cash flows. This arises from the need for more cash to support increases
in the bank balance, accounts receivable and inventory. This may be offset in part by increases
in accounts payable, short-term loans and accruals that arise from the expansion of business
activities.

For example, if we need to spend cash to build up inventory in connection with a long term
investment, then the increase in inventory is treated as a cash outflow when calculating an
initial investment. At the end of the project’s life, net working capital reverses, so a cash inflow
arises. In our example, when the project is terminated, inventory will be sold off, allowing
funds to be released for investment elsewhere.

Finding the Terminal Cash Flow

It can be rather confusing to determine the terminal cash flow for a replacement project. Both
the proceeds from the sale of the new asset, and the proceeds forgone from the sale of the old
asset must be considered.

If we purchase the new asset at time zero, then we will receive a cash inflow when we sell it at
the end of its life. Furthermore, we will forgo any sales proceeds which we would have earned
on the salvage value of the old asset at the end of its life. This is because, if we purchase the
new asset, we will sell the old asset at time zero. Consequently, the sales proceeds forgone
from the sale of the old asset at the end of its life are treated as a cash outflow. The sale proceeds
forgone from the old machine are included in terminal cash flows to ensure the incremental
cash flows are calculated - which is the difference between the cash flows from the new
machine and what we could have received from the old machine.

11
In reality, taxes arising from the sale of an asset would normally be paid in provisional tax instalments or
in the year following the sale as terminal tax is due 11 months after the company’s balance date.

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There are tax implications if we sell the new asset at the end of its life. If we incur a loss on
sale, we will gain a tax savings (a cash inflow). If we incur a gain on sale, we will have
additional tax to pay.

However, had we kept the old asset, we would have incurred a gain or loss on sale, and
additional tax or a tax saving at the end of its life. Therefore, as a result of acquiring the new
asset, either we fail to incur additional tax or we forgo a tax saving on the final year sale of the
old asset. A failure to incur additional tax is treated as a cash inflow, while to forgo a tax
saving is treated as a cash outflow.

Example: Powell Corporation

The initial investment example shown on page 529 for Powell Corporation has been re-worked
below to include the New Zealand treatment of straight-line depreciation over the asset’s 5 year
life, (i.e. $240,000/5 years = $48,000 depreciation per year), zero capital gains tax, and
assuming a 30% tax rate on ordinary income.

Book Value = Cost – accumulated depreciation

Book Value = $240,000 – ($48,000 x 3 years) = $96,000

In order to estimate taxes you can apply the following:

Take: lower of cost: $240,000

or proceeds: $280,000 $240,000
Less Book Value $ 96,000
Recovered depreciation $144,000
Tax to pay (30% tax rate) $43,200

Using the Alternative Initial Investment Format

After-tax proceeds from sale of old asset:
Proceeds from sale of old asset 280,000
Taxes on sale of old asset (43,200) 236,800
Less Installed cost of new asset:
Cost of new asset (380,000)
+ Installation costs (20,000) (400,000)
Change in net working capital (17,000)

Equals Initial Investment ($180,200)

Therefore an outlay of $180,200 will be required for Powell Corporation to undertake this
capital budgeting project. If you calculated the initial investment using the method presented
in Table 11.1 you should still arrive at $180,200 but it will be shown as a positive amount. We
prefer to show the initial investment as a negative value, as it reduces the firm’s cash balance.
This is logical and is consistent with how the initial investment is depicted using capital
budgeting techniques such as payback, NPV and IRR.

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Ethics & Capital Budgeting
As there is much subjectivity involved in estimating many of the inputs into the capital
budgeting process, there is considerable scope for unethical behaviour to bias financial decision
making. In larger firms, divisions and subsidiaries often compete with each other for a limited
pool of funds (i.e. there is capital rationing) to invest in new projects. Assuming all divisions
and management work towards maximising shareholder wealth then the group of projects that
maximises the NPV (or wealth) of the limited pool of funds will be chosen.

However, if an agency problem exists within the firm (i.e. contracting of managers does not
align their interest with shareholders) or there is poor ethical behaviour as discussed in ethics
Reading 1, then managers may put their own interests (or interests of their division by
“protecting their patch”) ahead of the entire firm. A manager of a division or subsidiary could
“tweak” any number of inputs. For example, manipulating cash inflows and outflows, cost of
capital inputs or inappropriate risk assessment and adjustment for the risk could enable a
manager to present a favourable analysis that meets or exceeds minimum project investment
acceptance criteria. This can lead to scarce funds being diverted from the firm’s total funding
pool and invested in managers’ poor ‘pet projects’ or investments that ‘protect their patch’ (and
therefore managers’ job security and rewards). This not only adversely affects the firm’s
shareholders but many other stakeholders. For example, this behaviour will result in fewer
funds being available for other divisions, which in turn negatively impacts on employees’ job
security and total rewards in those other divisions.

Another ethical issue arises when a project has been accepted and implemented but is failing
financially. Such projects should be discontinued. However, evidence shows that some
managers are biased toward continuing to invest in failing projects (throwing good money after
bad investments). Further, there is the strongest tendency to continue investing in failing
projects when agency problems exist and when managers demonstrate relatively lower levels
of ethical behaviour12. As such, strong ethical behaviour by individual managers reduces the
tendency to continue investing in failing projects. Further, it has been shown that the
establishment of a strong ethical environment in the workplace (improving ethical standards,
through training, rewards, sanction etc) is also beneficial in reducing the tendency for managers
to continue throwing good money at bad projects13.

12
Rutledge, R.W., and Karim, K.E. (1999) The influence of self-interest and ethical considerations on
managers’ evaluation judgements. Accounting, Organizations and Society, 24, 173-184.
13
Booth, P. and Schulz, A.K. (2004) The impact of an ethical environment on managers’ project evaluation
judgements under agency problem conditions. Accounting, Organizations and Society, 29, 473-488.

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