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Introduction to Capital Budgeting Pamela Peterson, Florida State University

O U T L I N E

I. Introduction II. The investment problem

III. Capital budgeting IV. Classifying investment projects V. Cash flow from investments

VI. Operating cash flows VII. Putting it all together

VIII. Practice problems and questions

I. Introduction

As long as a firm exists, it will invest in assets. Indeed, a firm invests in assets to continue to exist, and moreover, to grow. By investing to grow, a firm is at the same time investing to maximize the owners' wealth. To maximize the wealth of a firm's owners, its managers must regularly evaluate investment opportunities and determine which ones provide a return commensurate with their risk. Let's look at Firms A, B, and C, each having identical assets and investment opportunities, but that:

o Firm A's management does not take advantage of its investment opportunities and simply pays all of its earnings to its owners;

o Firm B's management only makes those investments necessary to replace any deteriorating plant and equipment, paying out any left-over earnings to its owners; and

o Firm C's management invests in all those opportunities that provide a return better than what the owners could have earned had they had the same amount of invested funds to invest themselves.

In the case of Firm A, the owners' investment in the firm is not what it could be as long as the firm has investment opportunities that are better than those available to owners. By not even making investments to replace deteriorating plant and equipment, Firm A will eventually shrink until it has no more assets.

In the case of Firm B, its management is not taking advantage of all profitable investments -- investments that provide a higher return than the return required by its owners. This means that there are foregone opportunities and owners' wealth is not maximized.

But in the case of Firm C, management is making all profitable investments, maximizing owners' wealth. Firm C will continue to grow as long as there are profitable investment opportunities and its management takes advantage of them. And Firm C represents most large corporations: continually making investments and growing over time.

II. The investment problem

Capital Investments

Firms continually invest funds in assets and these assets produce income and cash flows that the firm can then either reinvest in more assets or pay to its owners. These assets represent the firm's capital.

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Capital is the firm's total assets and is comprised of all tangible and intangible assets. These assets include physical assets (such as land, buildings, equipment, and machinery), as well as assets that represent property rights (such as accounts receivable, notes, stocks, and bonds). When we refer to capital investment, we are referring to the firm's investment in its assets.

The term "capital" also has come to mean the funds used to finance the firm's assets. In this sense, capital consists of notes, bonds, stock, and short-term financing. We use the term "capital structure" to refer to the mix of these different sources of capital used to finance a firm's assets.

The term "capital" in financial management, a firm's resources and the funds committed to these resources, does not mean the same thing in other fields. In accounting, the term "capital" means the owners' equity, the difference between the amount of a firm's assets and its liabilities. In economics, the term "capital" means the physical (real) of the firm, and therefore excludes the assets that represent property rights. In law the term "capital" refers to the amount of owners' equity required by statute for the protection of creditors. This amounts to the "stated capital", which often is the par value of the firm's stock.

The firm's capital investment decision may be comprised of a number of distinct decisions, each referred to as a project. A capital project is a set of assets that are contingent on one another and are considered together. Suppose a firm is considering the production of a new product. It must make a decision of whether or not to produce this new product. This capital project entails acquiring land, building facilities, and purchasing production equipment. And this project may also require the firm to increase its investment in its working capital -- inventory, cash, or accounts receivable. Working capital is the collection of assets needed for day-to-day operations that support a firm's long-term investments.

The investment decisions of the firm are decisions concerning a firm's capital investment. When we refer to a particular decision that financial managers must make, we are referring to a decision pertaining to a capital project.

Investment Decisions and Owners' Wealth Maximization

Let's see what we must evaluate in our investment decisions to maximize the wealth of owners of the firm we manage. We already know the value of the firm today is the present value of all its future cash flows. But we need to understand better where these future cash flows come from. They come from:

1. assets that are already in place, which are the assets accumulated as a result of all past investment decisions, and

2. future investment opportunities.

Future cash flows are discounted at a rate that represents investors' assessments of the uncertainty that these cash flows will flow in the amounts and when expected. To evaluate the value of the firm, we need to evaluate the risk of these future cash flows.

A project's business risk is reflected in the discount rate, which is the rate of return required to compensate the suppliers of capital (bondholders and owners) for the amount of risk they bear. From investors' perspective, the discount rate is the required rate of return (RRR). From the firm's perspective, the discount rate is the cost of capital -- what it costs the firm to raise a dollar of new capital.

Suppose a firm invests in a new project.

o If the project generates cash flows that just compensate the suppliers of capital for the risk they bear on this project (that is, it earns the cost of capital), the value of the firm does not change.

o If the project generates cash flows greater than needed to compensate them for the risk they take on, it earns more than the cost of capital, increasing the value of the firm.

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o If the project generates cash flows less than needed, it earns less than the cost of capital, decreasing the value of the firm.

How do we know whether the cash flows are more than or less than needed to compensate for the risk that they will indeed flow? If we discount all the cash flows at the cost of capital, we can assess how this project affects the present value of the firm. If the expected change in the value of the firm from an investment is:

o positive, the project returns more than the cost of capital; o negative, the project returns less than the cost of capital; o zero, the project returns the cost of capital.

Capital budgeting is the process of identifying and selecting investments in long-lived assets, where long-lived means assets expected to produce benefits over more than one year. In this reading, we first look at the capital budgeting process in general. After looking at the broad picture of how investment decisions are made, we look at how projects may be classified. This classification helps us identify of the cash flows we need to consider in our decisions. We then look at the mechanics of estimating future cash flows using estimates of future revenues, expenses, and depreciation. We summarize our analysis of cash flows with examples analyzing two different investment projects.

III. Capital Budgeting

A firm must continually evaluate possible investments. Investment decisions regarding long-lived assets are a part of the on-going capital budgeting process. Ideas about what projects to invest in are generated through facts gathered at lower management levels, where they are evaluated and screened. The suggested investments that pass this first level filter up through successive management levels toward top management or the board of directors, who make the decisions about which one will get how much capital. The stages in the typical capital budgeting process are described in Exhibit 1.

Before a firm begins thinking about capital budgeting, it must first determine its corporate strategy -- its broad set of objectives for future investment. For example, Anheuser-Busch Companies, Inc,'s objective is "... to extend its position as the world's leading brewer of quality products; increase its share of the domestic beer market to 50% by the mid-1990's; and increase its presence in the international beer market."

Consider the corporate strategy of Mattel, Inc., manufacturer of toys such as Barbie and Disney toys. Mattel's strategy in the 1990's is to become a full-line toy company and grow through expansion into the international toy market. In 1990, 1991, and 1992, Mattel entered into the activity toy, games, and plush toy markets, and, through acquisitions in Mexico, France and Japan, increased its presence in the international toy market. How does a firm achieve its corporate strategy? By making investments in long-lived assets that will maximize owners' wealth. Selecting these projects is what capital budgeting is all about.

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Exhibit 1: The Five Stages in the Capital Budgeting Process

1. INVESTMENT SCREENING AND SELECTION.

Projects consistent with the corporate strategy are identified. But projects don't simply walk into corporate headquarters. The firm must have some system for seeking or generating investment opportunities. Identifying investment opportunities is not necessarily the task of the financial manager. This task typically lies with the production, marketing, and research and development management of the firm.

2. THE CAPITAL BUDGET PROPOSAL.

A capital budget is proposed for the projects surviving the screening and selection process. The budget lists the recommended projects and the dollar amount of investment needed for each. This proposal may start as an estimate of expected revenues and costs, but as the project analysis is refined, data from marketing, purchasing, engineering, accounting, and finance functions are collected and put together.

3. BUDGETING APPROVAL AND AUTHORIZATION.

Projects included in the capital budget are authorized, allowing further fact gathering and analysis, and approved, allowing expenditures for the projects. In some firms, the projects are authorized and approved at the same time. In others, a project must first be authorized, requiring more research before it can be formally approved.Formal authorization and approval procedures are typically used on larger expenditures; smaller expenditures are at the discretion of management.

4. PROJECT TRACKING.

After a project is approved, work on it begins. The manager reports periodically on its expenditures, as well as on any revenues associated with it. This is referred to as project tracking, the communication link between the decision makers and the operating management of the firm. For example: tracking can identify cost over-runs; it can also identify that more marketing research is needed to better focus on the target market.

5. POST-COMPLETION AUDIT.

Following a period of time, perhaps two or three years after approval, projects are reviewed to see whether they should be continued. This re- evaluation is referred to as a post-completion audit. Thorough post- completion audits are not usually performed on every project since that would be too time consuming. Rather, they are performed on selected projects, usually the largest projects in a given year's budget for the firm or for each division. Post-completion audits enable the firm's management to see how well the cash flows realized correspond with the cash flows forecasted several years earlier.

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IV. Classifying Investment Projects

According to Their Economic Life

An investment generally provides benefits over a limited period of time, referred to as its economic life. The economic life or useful life of an asset is determined by:

o physical deterioration; o obsolescence; or o the degree of competition in the market for a product.

The economic life is an estimate of the length of time that the asset will provide benefits to the firm. After its useful life, the revenues generated by the asset tend to decline rapidly and its expenses tend to increase.

Typically, an investment requires an expenditure up-front -- immediately -- and provides benefits in the form of cash flows received in the future. If benefits are received only within the current period -- within one year of making the investment -- we refer to the investment as a short-term investment. If these benefits are received beyond the current period, we refer to the investment as a long-term investment and refer to the expenditure as a capital expenditure.

Any project representing an investment may comprise one or more assets. For example, a new product may require investment in production equipment, a building, and transportation equipment -- all making up the bundle of assets comprising the project we are evaluating. Short-term investment decisions involve, primarily, investments in current assets: cash, marketable securities, accounts receivable, and inventory. The objective of investing in short-term assets is the same as long-term assets: maximizing owners' wealth. Nevertheless, we consider them separately for two practical reasons:

3. Decisions about long-term assets are based on projections of cash flows far into the future and require us to consider the time value of money.

4. Long-term assets do not figure into the daily operating needs of the firm.

Decisions regarding short-term investments, or current assets, are concerned with day-to-day operations. And a firm needs some level of current assets to act as a cushion in case of unusually poor operating periods, when cash flows from operations are less than expected.

According to Their Risk

Suppose you are faced with two investments, A and B, each promising a $100 cash inflow ten years from today. If A is riskier than B, what are they worth to you today? If you do not like risk, you would consider A less valuable than B because the chance of getting the $100 in ten years is less for A than for B. Therefore, valuing a project requires considering the risk associated with its future cash flows.

The project's risk of return can be classified according to the nature of the project represented by the investment:

o Replacement projects: investments in the replacement of existing equipment or facilities. o Expansion projects: investments in projects that broaden existing product lines and existing

markets. o New products and markets: projects that involve introducing a new product or entering into a

new market. o Mandated projects: projects required by government laws or agency rules.

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Replacement projects include the maintenance of existing assets to continue the current level of operating activity. Projects that reduce costs, such as replacing older technology with newer technology or improving the efficiency of equipment or personnel, are also considered replacement projects.

To evaluate replacement projects we need to compare the value of the firm with the replacement asset to the value of the firm without that same replacement asset. What we're really doing in this comparison is looking at opportunity costs: what cash flows would have been if the firm had stayed with the old asset.

There's little risk in the cash flows from replacement projects. The firm is simply replacing equipment or buildings already operating and producing cash flows. And the firm typically has experience in managing similar new equipment.

Expansion projects are intended to enlarge a firm's established product or market. There is little risk associated with expansion projects. The reason: A firm with a history of experience in a product or market can estimate future cash flows with more certainty when considering expansion than when introducing a new product outside its existing product line. Investment projects that involve introducing new products or entering into new markets are riskier than the replacement and expansion projects. That's because the firm has little or no management experience in the new product or market. Hence, there is more uncertainty about the future cash flows from investments in new product or new market projects. A firm is forced or coerced into its mandated projects. These are government mandated projects typically found in "heavy" industries, such as utilities, transportation, and chemicals, all industries requiring a large portion of their assets in production activities. Government agencies, such as the Occupational Health and Safety Agency (OSHA) or the Environmental Protection Agency (EPA), may impose requirements that firms install specific equipment or alter their activities (such as how they dispose of waste).

According to Their Dependence on Other Projects

In addition to considering the future cash flows generated by project, a firm must consider how it affects the assets already in place -- the results of previous project decisions -- as well as other projects that may be undertaken. Projects can be classified as follows according to the degree of dependence with other projects: independent projects, mutually exclusive projects, contingent projects, and complementary projects.

An independent project is one whose cash flows are not related to the cash flows of any other project. In other words, accepting or rejecting an independent project does not affect the acceptance or rejection of other projects. An independent project can be evaluated strictly on the effect it will have on the value of a firm without having to consider how it affects the firm's other investment opportunities, and vice versa. Projects are mutually exclusive if the acceptance of one precludes the acceptance of other projects. There are some situations where it is technically impossible to take on more than one project. For example, suppose a manufacturer is considering whether to replace its production facilities with more modern equipment. The firm may solicit bids among the different manufacturers of this equipment. The decision consists of comparing two choices:

9. Keeping its existing production facilities, or 10. Replacing the facilities with the modern equipment of one manufacturer.

Because the firm cannot use more than one production facility, it must evaluate each bid and determine the most attractive one. The alternative production facilities are mutually exclusive projects: the firm can accept only one bid. The alternatives of keeping existing facilities or replacing them are also mutually exclusive projects. The firm cannot keep the existing facilities and replace them!

Contingent projects are dependent on the acceptance of another project. Suppose a greeting card company develops a new character, Pippy, and is considering starting a line of Pippy cards. If Pippy catches on, the firm will consider producing a line of Pippy T-shirts -- but only if the Pippy character

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becomes popular. The T-shirt project is a contingent project. It is contingent on the company (1) taking on the Pippy project and (2) Pippy's success.

Another form of dependence is found in complementary projects. Projects are complementary projects if the investment in one enhances the cash flows of one or more other projects. Consider a manufacturer of personal computer equipment and software. If it develops new software that enhances the abilities of a computer mouse, the introduction of this new software may enhance its mouse sales as well.

V. Cash flow from investments

Incremental Cash Flows

A firm invests only to make its owners "better off", meaning increasing the value of their ownership interest. A firm will have cash flows in the future from its past investment decisions. When it invests in new assets, it expects the future cash flows to be greater than without this new investment. Otherwise it doesn't make sense to make this investment. The difference between the cash flows of the firm with the investment project and the cash flows of the firm without the investment project -- both over the same period of time -- is referred to as the project's incremental cash flows.

To evaluate an investment, we'll have to look at how it will change the future cash flows of the firm. We will be examining how much the value of the firm changes as a result of the investment. The change in a firm's value as a result of a new investment is the difference between its benefits and its costs:

Project's change in the value of the firm = Project's benefits - Project's costs.

A more useful way of evaluating the change in the value is the breakdown the project's cash flows into two components

1. The present value of the cash flows from the project's operating activities (revenues and operating expenses), referred to as the project's operating cash flows (OCF) ; and

2. The present value of the investment cash flows, which are the expenditures needed to acquire the project's assets and any cash flows from disposing the project's assets.

or,

Change in the value of the firm =

Present value of the change in operating cash flows provided by the project +

Present value of investment cash flows

The present value of a project's operating cash flows is typically positive (indicating predominantly cash inflows) and the present value of the investment cash flows is typically negative (indicating predominantly cash outflows).

Investment Cash Flows

When we consider the cash flows of an investment we must also consider all the cash flows associated with acquiring and disposing of assets in the investment. An investment may comprise:

o one asset or many assets; o an asset purchased and another sold; and o cash outlays that occur at the beginning of the project or spread over several years.

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Let's first become familiar with cash flows related to acquiring assets; then we'll look at cash flows related to disposing assets.

Asset Acquisition

In acquiring any asset, there are three cash flows to consider:

1. Cost of the asset, 2. Set-up expenditures, including shipping and installation; and 3. Any tax credit.

The tax credit may be an investment tax credit or a special credit -- such as a credit for a pollution control device -- depending on the tax law. Cash flow associated with acquiring an asset is:

Cash flow from acquiring assets = Cost + Set-up expenditures - Tax credit.

Suppose the firm buys equipment that costs $100,000 and it costs $10,000 to install it. If the firm is eligible for a 10% tax credit on this equipment (that is, 10% of the total cost of buying and installing the equipment) the change in the firm's cash flow from acquiring the asset of $99,000:

Cash flow from acquiring assets = $100,000 + $10,000 - 0.10($100,000+10,000)

Cash flow from acquiring assets = $100,000 + $10,000 - $11,000

Cash flow from acquiring assets = $99,000.

The cash outflow is $99,000 when this asset is acquired: $110,000 out to buy and install the equipment and $11,000 in from the reduction in taxes. What about expenditures made in the past for assets or research that would be used in the project we're evaluating? Suppose the firm spent $1,000,000 over the past three years developing a new type of toothpaste. Should the firm consider this $1,000,000 spent on research and development when deciding whether to produce this new project we are considering? No! These expenses have already been made and do not affect how the new product changes the future cash flows of the firm. We refer to this $1,000,000 as a sunk cost and do not consider it in the analysis of our new project. Whether or not the firm goes ahead with this new product, this $1,000,000 has been spent. A sunk cost is any cost that has already been incurred that does not affect future cash flows of the firm.

Let's consider another example. Suppose the firm owns a building that is currently empty. Let's say the firm suddenly has an opportunity to use it for the production of a new product. Is the cost of the building relevant to the new product decision? The cost of the building itself is a sunk cost since it was an expenditure made as part of some previous investment decision. The cost of the building does not affect the decision to go ahead with the new product.

Suppose the firm was using the building in some way producing cash (say, renting it) and the new project is going to take over the entire building. The cash flows given up represent opportunity costs that must be included in the analysis of the new project. However, these forgone cash flows are not asset acquisition cash flows. Because they represent operating cash flows that could have occurred but will not because of the new project, they must be considered part of the project's future operating cash flows. Further, if we incur costs in renovating the building to manufacture the new product, the renovation costs are relevant and should be included in our asset acquisition cash flows.

Asset Disposition

Many new investments require getting rid of old assets. At the end of the useful life of an asset, the firm may be able to sell it or may have to pay someone to haul it away. If the firm is making a decision that

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involves replacing an existing asset, the cash flow from disposing of the old asset must be figured in since it is a cash flow relevant to the acquisition of the new asset.

If the firm disposes of an asset, whether at the end of its useful life or when it is replaced, two types of cash flows must be considered:

1. what you receive or pay in disposing of the asset; and 2. any tax consequences resulting from the disposal.

Cash flow from disposing assets = Proceeds or payment from disposing assets - Taxes from disposing assets.

The proceeds are what you expect to sell the asset for if you can get someone to buy it. If the firm must pay for the disposal of the asset, this cost is a cash outflow.

Consider the investment in a gas station. The current owner may want to leave the business (retire, whatever), selling the station to another gas station proprietor. But if a buyer cannot be found because of lack of gas buyers in the area, the current owner may be required to remove the underground gasoline storage tanks to prevent environmental damage. Thus, a cost is incurred at the end of the asset's life.

The tax consequences are a bit more complicated. Taxes depend on: (1) the expected sales price, and (2) the book value of the asset for tax purposes at the time of disposition.

If a firm sells the asset for more than its book value but less than its original cost, the difference between the sales price and the book value is a gain, taxable at ordinary tax rates. If a firm sells the asset for more that its original cost, then the gain is broken into two parts:

1. Capital gain: the difference between the sales price and the original cost; and 2. Recapture of depreciation: the difference between the original cost and the book value.

The capital gain is the benefit from the appreciation in the value of the asset and may be taxed at special rates, depending on the tax law at the time of sale. The recapture of depreciation represents the amount by which the firm has over-depreciated the asset during its life. This means that more depreciation has been deducted from income (reducing taxes) than necessary to reflect the usage of the asset. The recapture portion is taxed at the ordinary tax rates, since this excess depreciation taken all these years has reduced taxable income.

If a firm sells an asset for less than its book value, the result is a capital loss. In this case, the asset's value has decreased by more than the amount taken for depreciation for tax purposes. A capital loss is given special tax treatment:

o If there are capital gains in the same tax year as the capital loss, they are combined, so that the capital loss reduces the taxes paid on capital gains, and

o If there are no capital gains to offset against the capital loss, the capital loss is used to reduce ordinary taxable income.

The benefit from a loss on the sale of an asset is the amount by which taxes are reduced. The reduction in taxable income is referred to as a tax-shield, since the loss shields some income from taxation. If the firm has a loss of $1,000 on the sale of an asset and has a tax rate of 40%, this means that its taxable income is $1,000 less and its taxes are $400 less than they would have been without the sale of the asset.

Suppose you are evaluating an asset that costs $10,000 that you expect to sell in five years. Suppose further that the book value of the asset for tax purposes will be $3,000 after five years and that the firm's tax rate is 40%. What are the expected cash flows from disposing this asset? If you expect the firm to

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sell the asset for $8,000 in five years, $10,000 - 3,000 = $7,000 of the asset's cost will be depreciated, yet the asset lost only $10,000 - 8,000 = $2,000 in value. Therefore, the firm has over-depreciated the asset by $5,000. Since this over-depreciation represents deductions to be taken on the firm's tax returns over the five years that don't reflect the actual depreciation in value (the asset doesn't lose $7,000 in value, only $2,000), this $5,000 is taxed at ordinary tax rates. If the firm's tax rate is 40%, the tax = 40% x $5,000 = $2,000.

The cash flow from disposition is the sum of the direct cash flow (someone pays us for the asset or the firm pays someone to dispose of it) and the tax consequences. In this example, the cash flow is the $8,000 we expect someone to pay the firm for the asset, less the $2,000 in taxes we expect the firm to pay, or $6,000 cash inflow.

Suppose instead that you expect the firm to sell this asset in five years for $12,000. Again, the asset is over-depreciated by $7,000. In fact, the asset is not expected to depreciate, but rather appreciate over the five years. The $7,000 in depreciation is recaptured after five years and taxed at ordinary rates: 40% of $7,000, or $2,800. The $2,000 capital gain is the appreciation in the value of the asset and may be taxed at special rates. If the tax rate on capital gain income is 30%, you expect the firm to pay 30% of $2,000, or $600 in taxes on this gain. Selling the asset in five years for $12,000 therefore results in an expected cash inflow of $12,000 - 2,800 - 600 = $8,600.

Suppose you expect the firm to sell the asset in five years for $1,000. If the firm can reduce its ordinary taxable income by the amount of the capital loss, $3,000 - 1,000 = $2,000, our tax bill be 40% of $2,000, or $800 because of this loss. We refer to this reduction in the taxes as a tax-shield, since the loss "shields" $2,000 of income from taxes Combining the $800 tax reduction with the cash flow from selling the asset, the $1,000, gives the firm a cash inflow of $1,800.

Let's also not forget about disposing of any existing assets. Suppose the firm bought equipment ten years ago and at that time expected to be able to sell fifteen years later for $10,000. If the firm decides today to replace this equipment, it must consider what it is giving up by not disposing of an asset as planned. If the firm does not replace the equipment today, it would continue to depreciate it for five more years and then sell it for $10,000; if the firm replaces the equipment today, it would not have five more years' depreciation on the replaced equipment and it would not have $10,000 in five years (but perhaps some other amount today). This $10,000 in five years, less any taxes, is a forgone cash flow that we must figure into the investment cash flows. Also, the depreciation the firm would have had on the replaced asset must be considered in analyzing the replacement asset's operating cash flows.

VI. Operating Cash Flows

In the simplest form of investment, there will be a cash outflow when the asset is acquired and there may be either a cash inflow or an outflow at the end of its economic life. In most cases these are not the only cash flows -- the investment may result in changes in revenues, expenditures, taxes, and working capital. These are operating cash flows since they result directly from the operating activities -- the day- to-day activities of the firm.

What we are after here are estimates of operating cash flows. We cannot know for certain what these cash flows will be in the future, but we must attempt to estimate them. What is the basis for these estimates? We base them on marketing research, engineering analyses, operations research, analysis of our competitors -- and our managerial experience.