Capital Budgeting and Cash Flow

Estimation
By:

Rodelyn Nove Cruz

Noelyn Cordero
The Capital Budgeting Process
The process of identifying,
analyzing, and selecting
investment projects whose
returns (cash flows) are expected
to extend beyond one year.
Capital budgeting involves

Generating investment project proposals

consistent with the firms strategic objectives
Estimating after-tax incremental operating cash
flows for investment projects
l Evaluating project incremental cash flows
Capital budgeting involves

Selecting projects based on a value-maximizing

acceptance criterion
Reevaluating implemented investment projects
continually and performing post audits
for completed projects
Cash Flow Estimation
Basic Concepts
Overview
Most difficult aspect of capital budgeting
Long time frame
Leads to uncertainty
Typical bias:
overstate revenues and understate costs
Nevertheless, it must be carried out
Relevant Cash Flows Only
These are called incremental cash flows
That is, the CFs that occur due to the
undertaking of the project
Thus, sunk costs must NOT be included
Sunk Cost
Expenditures already made
Opportunity Costs
Must be included, though can be difficult to
calculate.
What could have been earned otherwise or
best alternative if not this project
Externalities
Impact of the project in consideration (the
capital budgeting project) onto existing projects
If the project benefits other existing projects,
include the benefit to the existing projects into
the CFs of this project (positive)
If the project hurts other existing projects
(cannibilize), include this cost into the CFs
Depreciable Basis
The amount of Pesos that is used to calculate
depreciation (what we multiply the depreciation
rates by)
Only long term assets plus shipping,
modifications, installation
Does not include NWC investments
Depreciation: use the fastest possible (MACRS)
Net Working Capital
Initial investment needed to support the capital
investment
Ex: inventories or cash
Can be offset by free financing such as AP
So the net effect is NWC
Assume recovery of this investment at the end of
the project
Net Salvage
At the end of the project, we assume that the
long term investment will be sold (salvage)
This must be adjusted for tax effects (thus net)
Salvage value +- tax impact= net salvage
Tax impact:
If gain (salvage > book value), pay taxes on that
gain (-) (reduces the salvage value)
If a loss (salvage < book value), tax savings on the
loss (+) (increase the salvage value)