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Course 2: Capital Budgeting Analysis
Chapter 2: Calculating the Discounted Cash Flows of ProjectsIn capital budgeting analysis we want to determine the after tax cash flows associated with capital projects. We are concerned with all relevant changes or differences to cash flows once we invest in the project.
Understanding "Relevancy"One question that we must ask in capital budgeting is what is relevant. Here are some examples of what is relevant to project cash flows:
1. Depreciation: Capital assets are subject to depreciation and we need to account for depreciation twice in our calculations of cash flows. We deduct depreciation once to calculate the taxes we pay on project revenues and we add back depreciation to arrive at cash flows because depreciation is a non-cash item.
2. Working Capital: Major investments may require increases to working capital. For example, new production facilities often require more inventories and higher salaries payable. Therefore, we need to consider the net change in working capital associated with our project. Changes in net working capital will sometimes reverse themselves at the end of the project.
3. Overhead: Many capital projects can result in increases to allocated overheads, such as computer support services. However, the subjective nature of overhead allocations may not make any difference at all. Therefore, you need to assess the impact of your capital project on overhead and determine if these costs are relevant.
4. Financing Costs: If we plan on financing a capital project, this will involve additional cash flows to investors. The best way to account for financing costs is to include them within our discount rate. This eliminates the possibility of double-counting the financing costs by deducting them in our cash flows and discounting at our cost of capital which also includes our financing costs.
We also need to ignore costs that are sunk; i.e. costs that will not change if we invest in the project. For example, a new product line may require some preliminary marketing research. This research is done regardless of the project and thus, it is sunk. The concept of sunk costs and relevant costs applies to all types of financing decisions.
So far, we have covered present values and relevancy within capital budgeting. We now can proceed to calculate the present value of relevant cash flows. Once we have determined the present value of cash flows, we will have a basis for comparing our initial investment. Both values (future cash flows and initial investment) will be expressed in current values. The net of these two amounts will tell us how much value we will create or destroy by investing in a project.
We will receive $ 5,788 of cash flow each year by investing in this new assembly machine. Since we have a salvage value, we have a terminal cash flow associated with this project.
Calculating the Present Value of Cash FlowsOur next step is to calculate present values of our two cash flow streams. We will use our cost of capital to discount the cash flows. We will assume that our cost of capital is 12%. We will use the present value tables in Exhibits 1 and 2 for finding the appropriate discount factor per the life of our cash streams and the 12% cost of capital.
Calculating Net InvestmentNow that we have the current value of $ 22,709 for our cash flows, we need to compare this to our investment amount. Our investment is the total cash outlay we must make today and it includes:
- All cash paid out to invest in the project and place it into service, such as installation, transportation, etc.
- Net proceeds from the disposal of any old equipment that will be replaced by the new equipment.
- Any taxes paid and/or tax benefits received from making the investment.
So we now have a current value for our cash flows of $ 22,709 and a total net investment of $ 24,100. These amounts are derived by looking at three different types of cash flows:
1. Relevant cash flows during the life of the project.
2. Terminal cash flows at the end of the project.
3. Initial cash flows (net investment).
Chapter 2 pointsUnderstanding "Relevancy"
Calculating the Present Value of Cash Flows
Calculating Net Investment