Capital Budgeting and Cash Flow Analysis

The Finance Function

The primary objective of a financial manager and a corporation is to maximize the current value of shareholders' wealth by making informed investing and financing decisions.

Capital Budgeting

Capital budgeting is the process of:
- Identifying
- Analyzing
- Selecting investment projects.
These projects are expected to generate returns (cash flows) extending beyond one year.
The ultimate goal of capital budgeting is to increase shareholders' wealth.

Statement of Financial Position

The statement provides a snapshot of a company's assets, liabilities, and equity at a specific point in time.
Assets are categorized into:
- Non-current (fixed) assets
  - Tangible assets
  - Intangible assets
  - Investments
- Current assets
  - Inventory (stock)
  - Trade and other receivables (debtors)
  - Current asset investments and deposits
  - Cash at bank and in hand
Liabilities are divided into:
- Current liabilities
  - Creditors: amount due within one year
- Non-current liabilities
  - Creditor amounts due in more than one year
  - Provisions for liabilities and charges
Equity consists of:
- Called-up share capital
- Share premium account
- Revaluation reserve
- Retained earnings
- Non-controlling (minority) interests
The accounting equation is: Assets = Liabilities + Equity.

Classification of Investment Project Proposals

Investment project proposals can be classified into several categories:
1. New products or expansion of existing products and facilities.
2. Replacement of existing equipment or buildings.
3. Research and development.
4. Exploration.
5. Other (e.g., safety or pollution related).

Classification of Investment Projects

Projects can also be classified based on their purpose:
- Profit-adding project
- Profit-maintaining project
- Expansion project
- Product Improvement project
- Necessity project
- Replacement Project
- Cost Improvement project

The Importance of Cash Flow

Cash flow measures the actual inflow and outflow of cash.
Profits represent an accounting measure of periodic performance.
A firm can spend its operating cash flow but not its net income.
Some firms have net losses and yet can pay dividends from cash balances.
Others show profits and may not have the cash available for even a small dividend to shareholders.
Cash flow is broader than net income.

Relevant Cash Flows

Relevant cash flows are those that will only occur if the project is accepted.
These cash flows are called incremental cash flows.
The stand-alone principle allows analyzing each project in isolation from the firm, focusing solely on incremental cash flows.

Incremental Cash Flows

Incremental costs and benefits should be the focus.
To determine if a cash flow is incremental, ask: "Would this cash flow still exist if the project did not exist?"
- No? Include the cash flow in the analysis.
- Yes? Do not include the cash flow in the analysis.

Discount Incremental Cash Flows

A project’s success depends on the extra cash flows it produces.
Steps to calculate Incremental Cash Flow:
1. Calculate the firm’s cash flows if it goes ahead with the project.
2. Calculate the cash flows if the firm doesn’t go ahead with the project.
3. Take the difference to find the incremental cash flow of the project. $Incremental Cash Flow = Cash Flow<em>{with\ the\ Project} - Cash Flow</em>{without\ the\ Project}$

Estimating Cash Flow for Projects: Incremental Cash Flow

For expansion, replacement, or new project analysis, incremental effects on revenues and expenses must be considered.
Careful estimation and evaluation of the timing and magnitude of incremental cash flows is very important.
Eight important issues to be considered and valued:
- Sunk costs
- Opportunity cost
- Erosion
- Synergy gains
- Working capital
- Capital expenditures
- Capital Allowance and cost recovery of assets
- Tax implications

Components of Project Cash Flows

Operating Cash Flows
- Sales
- Variable Costs
- Fixed Cash Costs
- Opportunity Cost
- Capital Allowance
Investment Cash Flows
- Plant, Machinery, and Building
- Residual Value
- Working Capital

Sunk Costs

Sunk costs are expenses that have already been incurred or will be incurred, regardless of the decision to accept or reject a project.
These costs, although part of the income statement, should not be considered as part of the relevant cash flows when evaluating a capital budgeting proposal.
Example:
- A company hires an architect to draw up a building concept before deciding on a new building. The architect's costs are a sunk cost and should NOT be included.
- If the company moves forward with the building and hires the same architect, the costs are part of the project and should be included.

Opportunity Costs

Opportunity costs are costs that may not be directly observable or obvious but result from benefits being lost as a result of taking on a project.
For example, if a firm decides to use an idle piece of equipment as part of a new business, the value of the equipment that could be realized by either selling or leasing it would be a relevant opportunity cost.
These costs should be included because of other uses resources could be put to.
Example:
- Delta Ltd. is expanding operations and using existing shelving. If the shelving could be sold for £2,000, this is an opportunity cost.
- If Delta Ltd. uses empty space in their building for expansion, and the space has no potential for generating income, there is no opportunity cost.

Cannibalization or Erosion

Erosion costs arise when a new product or service competes with revenue generated by a current product or service offered by a firm.
For example, if a store offers two types of photo-copying services, a newer, more expensive choice and an older economical one.
Some of the revenues generated from the newer copier will be from older repeat customers that would have used the older copier and should therefore be eliminated from revenue for the incremental cash flows of the new copier.
Example:
- Delta Ltd. expects £150,000 - £140,000 in sales from new machines, but the new machines will affect the sales of the previous model. Loss contribution is estimated at £2,000 in the four years of the new machines. This £2,000 is the erosion cost.

Synergy Gains

Synergy gains represent impulse purchases or sales increases for other existing products related to the introduction of a new product.
For example, if a gas station with a convenience store attached, adds a line of fresh donuts and bagels, the sales of coffee and milk, would result in synergy gains.
- Substitute products mean erosion.
- Complementary products mean synergy gains.
Example: If Delta introduces new machines, it will increase the sales of accessories and spare parts. Estimated contributions from these items is £30,000 per year.

Working Capital

Additional cash flows arise from changes in current assets such as inventory and receivables and current liabilities such as accounts payables that occur as a result of a new project.
Generally, at the end of the project, these additional cash flows are recovered and must be accordingly shown as cash inflows.
Even though the net cash outflows -- due to increase in net working capital at the start-- may equal the net cash inflow arising from the liquidation of the assets at the end, the time value of money effects make these costs relevant.

Capital Spending, Depreciation and Capital Allowance

Depreciation: a method of allocating the cost of a tangible asset over its useful life.
Firms can choose any method of depreciation for a certain class of assets
In Europe, for tax purposes, capital allowances can be claimed when you buy assets that you keep to use in your business, eg: equipment, machinery, business vehicles(known as plant and machinery).
You can deduct some or all of the value of the item from your profits before you pay tax.
Tax Capital Allowance
- Reducing balance method vs straight line method

Capital Spending and Capital Allowance

The two reasons we need to deal with Capital Allowance when doing capital budgeting problems are:
1. The tax flow implications from the annual operating cash flow (OCF).
2. The gain or loss at disposal of a capital asset.
Example:
- Delta purchased a new plant to manufacture its new machines as the existing plant was running out of capacity. New plants cost Delta £200,000 with installation and shipping cost £50,000. Useful life is estimated to be 4 years after which it would have a residual value of £20,000.
- Total cost of plant= Cost of plant+ shipping and installation costs => Total cost of plant= £200,000+£50,000=£250,000.
- Residual value=£20,000
- Capital Allowance Calculation for 4 years at 18% reducing balance method:
  - Year 1: Capital Allowance = £250,000 x 0.18 = £45,000; Remaining Value = £250,000 - £45,000 = £205,000
  - Year 2: Capital Allowance = £205,000 x 0.18 = £36,900; Remaining Value = £205,000 - £36,900 = £168,100
  - Year 3: Capital Allowance = £168,100 x 0.18 = £30,258; Remaining Value = £168,100 - £30,258 = £137,842
  - Year 4: Capital Allowance = £137,842 - £20,000 = £117,842; Remaining Value = 0

Beware of Allocated Overhead Costs

Accountants will allocate costs, such as rent, heat, or electricity to a firm’s operations.
Allocated costs are not related to any particular project, but they must be paid anyways.
When analyzing a project for acceptance, include only the extra expenses which would result from the project.
If a project generates extra overhead costs, they should be included in your analysis.
However, if the firm would incur the overhead costs whether it takes on the project or not, then those costs are not incremental.
If they are not incremental, they should not be included in the analysis.
Example: Suppose company allocates central administrative costs to product lines at a rate of 5% of product line sales for internal performance and profitability reporting:
Therefore allocated cost per year in be reflected in P&L not necessarily a project cash flow
Issue: Extra cash outlay caused by the project ? How much cash cost is Attributable?
- Identify incremental cash costs attributable to project (estimate), and ignore allocation.

Forecasting Cash Flows: The Ten Commandments

Estimate cash flows only on an Incremental Basis
Forget sunk costs: cost incurred in the past and irreversible
Include all externalities - the effects of the project on the rest of the firm - e.g., cannibalization or erosion & include effects of Synergy
Do not forget overhead costs; be careful some of the costs may be just allocations.
Capital Allowance is not a cash flow, but it affects taxation (include). Add back once taxes are calculated.
Do not ignore investment in fixed assets (Capital Expenditures)
Don’t forget the residual value
Do not ignore investment in net working capital
Opportunity costs cannot be ignored
Do not add financing cost? WHY?