Capital Budgeting Process

In the previous chapter we went through three techniques for analyzing capital budgeting projects. However, in all of those cases we had after tax cash flows given to us for one or more projects. Unfortunately, this is the easy part. Successful capital budgeting requires us to

• Find projects that fit our corporate strategy
• Estimate all relevant after-tax cash flows associated with the project
• Follow-up on the project.

Finding Appropriate Projects

The first stage of the capital budgeting process is to develop capital budgeting ideas. What types of long-term investment projects should the company consider undertaking. Some projects will be fairly simple expansion plans or replacements of old buildings or machinery. Other projects will be more complicated and involve the development and introduction of new projects. The key is to make sure that the projects being considered fit the goals of the organization. At this stage, the project is not being analyzed to determine if it will be undertaken or not, merely if it is a project worthy of consideration.

Estimating Relevant After-Tax Cash Flows

In order to calculate the NPV, IRR, or PP for the project, we need to know the cash flows. These do not mystically appear as it may seem from the problems in Chapter Eight. Instead they must be estimated. This is one of the (if not the) most important step in the capital budgeting process. If we poorly estimate the cash flows, the calculated NPV will be meaningless. Essentially, the old phrase "Garbage In, Garbage Out" is very appropriate here. Unfortunately, this is the most difficult step as it involves many estimations for things that may not happen for the next 5 to 10 years.

The estimation of cash flows can be broken down into 3 separate categories:

• Initial Cash Flows
• Operating Cash Flows
• Terminal Cash Flows

Initial Cash Flow

The initial cash flow consists of all cash flows spent at the time the project is undertaken (CF₀). Some typical cash flows that fall under this category are:

• Initial purchase price of new equipment
• Cost of training personnel associated with project
• Cost of installation
• Increase in inventory associated with project
• Increase in accounts receivable associated with project

An increase in accounts receivable does not seem intuitively to be a cash expense. However, accounts receivable are an asset and if any asset is increased, it must be offset by some sort of financing. Therefore, if our accounts receivable increase by $10,000, we may finance that with a short-term loan.

Another area to be careful for here is sunk costs. Sunk costs (already been spent) regardless of whether the project is accepted or not. For example, if we have spent $10,000 gathering information on expected cash flows and feasibility of a project, that $10,000 should NOT be included in the cash flows. Whether we accept or reject the project, that money has already been spent and is not a marginal cost associated with the project

In reality, initial cash flows will tend to occur over a period of time as opposed to one moment in time. However in our analysis, we simplify things by saying all initial cash flows take place at time period 0 (the start of the project).

Operating Cash Flows

The operating cash flows take place over the life of the project. These cash flows are essentially all cash inflows associated with the project less all cash outflows associated with the project less taxes. We will use the following formula to calculate after-tax operating cash flows:
CF_t = CFBT_t(1 - T) + Dep_t(T)

Where CF = the after-tax cash flow
        CFBT= the before-tax cash flows (inflows less outflows)
        Dep = Depreciation associated with the project for that year
        T = the firm's marginal tax rate
        t = year t  

Depreciation can be calculated either through the straight line method or the modified accelerated cost recovery system (MACRS). Under the straight-line method, the annual depreciation is equal to the purchase price of the equipment divided by the number of years the equipment will be depreciated over (salvage value is not considered). Using the MACRS method, the purchase price is multiplied by the appropriate MACRS factor from the tables [there is one in your book (p. 374), also there will by a table handed out in class for exams and quizzes]. For simplicity, we will assume that just the purchase cost of the new equipment is being capitalized and depreciated.

Terminal Cash Flow

The terminal cash flow represents all cash flows that occur at the end of the project. Typical examples of terminal cash flows are:

• After-tax cash flow associated with the sale of equipment
• Disposal costs
• Inventory or Accounts Receivable dropping down to their previous level

The after-tax cash flow associated with the sale of equipment is the tricky aspect of terminal cash flows. Rarely does the sales price equal the after-tax cash flow. Instead we must compare the book value to the sales price to determine the tax impact, then add in the tax savings or subtract the tax paid. The easiest way to handle this is to use the following formula
Value of Sale = Sale Price - (Sale Price - Book Value)(T)

If you are a little rusty on accounting terminology, the book value of the equipment is just the original price that was paid for it less the accumulated depreciation up to today.

Project Follow-Up

Once the project has been undertaken, it is a good idea to follow-up on its progress. From this you can see if your cash flow forecasts were too optimistic or too pessimistic. One thing to keep in mind is that our cash flows will rarely be right on, so we are looking for trends more than at one specific projects. Do we tend to forecast cash flows that are higher than what we see develop on average? If yes, than we need to take this tendency into account when forecasting cash flows for future projects.

Interdependent Projects

As mentioned in Chapter Eight, occasionally projects can not be classified simply as independent or mutually exclusive. These interdependent projects can be COMPLIMENTS in which taking project A and project B together generates higher cash flows (either due to higher revenues or lower costs) than we would expect by simply adding the two sets of cash flows together. Alternatively, these projects could be SUBSTITUTES in which taking project A and project B together generate lower cash flows than we would expect by simply adding the two sets of cash flows together. When we consider capital budgeting projects that are interdependent, we calculate the NPVs of each project separately and as a pair then choose the option that generates the highest NPV.