Capital Budgeting: Estimating Project Cash Flows and Making a Reasoned Decision

The Basic Idea of Capital Budgeting

Task:

The basic idea of capital budgeting is simple: 1) find a project that you think might be profitable and will be worth more than it costs, 2) determine how much it will cost to finance this project (WACC calculation) this is the material in Chapter 11, 3) estimate the net cash flows from the project itself, we deal with this in Chapter 12, and then 4) combine these two in a methodology that will allow you to make a reasoned decision, which is the work of Chapter 13.

Once a firm has its WACC calculated it must then estimate the amount of cash flows that the proposed capital project will generate. Clearly these two activities do not need to be done sequentially and in fact in larger corporations with big capital budgeting operations they will be tackled simultaneously.

The holy grail of cash flow estimation is to consider ONLY those cash flows that are applicable if we were to accept the new project. Any cash in or out flows that the firm would receive or have to make anyway should NOT be considered. Some cash flows to/from the project are obvious and easy to identify and some are not, these latter ones include:

Opportunity costs: If we did not use an existing resource for our project, it could have been used to generate cash flows for another project, so our project must be charged for those foregone cash flows

Sunk costs:  If a firm has already paid an expense or is obligated to pay one in the future regardless of whether the project is undertaken, it is a sunk cost and should never be considered in the project cash flows

Substitutionary and Complementary effects: If a new project will reduce or increase cash flows for existing products or services then those changes are incremental to the project and should be included in the project cash flows.

Financing costs: Financing costs are never included as incremental project cash flows  because if we included them in the project cash flows we would be double-counting them.  Interest paid on debt and dividends paid on stock. We do include these costs in the analysis, but they are included as part of the Weighted Average Cost of Capital (WACC) that we use to discount the cash flows.

We want to establish an estimate of total project cash flow and this has a number of subparts:

Estimating Cash Flows for Capital Projects

Depreciation: The depreciable basis for real property is calculated as: Cost + sales tax + freight charges + installation and testing.
Operating Cash Flow: OCF = EBIT – Taxes + Depreciation. Note: It is useful to use a pro-forma income statement approach to calculate operating cash flows and please remember to leave out interest expense as we discussed earlier.

Changes in Gross Fixed Assets: For most projects we need to calculate the change in gross fixed assets at the beginning of the project (time 0) and at the end of the project. At the beginning of the project the change in gross fixed assets equals the asset’s depreciable basis. At the end of the project we need to consider the tax consequences of the sale of the asset and if we sell the asset for more than its book value we have a gain on the sale and if we sell the asset for less than book value we have a loss on the sale.

Changes in Net Working Capital; for some projects we might assume that NWC increases at time zero (resulting in a negative cash flow) and decreases at the end of the project (resulting in a positive cash flow).

All of these activities will influence net cash flows applicable to the project and will be brought together at the end of the day into a single grand calculation for the project as a whole. Please note that this is a stylized description that we use in class to teach you the basis of corporate finance. In practice you will also have to consider a whole range of other potential influences on cash flows such as accelerated depreciation, more flotation costs, and project with different life spans. However in terms of the basic material for this course at this stage of your education, what we have described herein is more than enough.

In previous chapters we learned how to calculate the firm’s cost of capital (Chapter 11) and estimate a project’s cash flows (Chapter 12), now, we need to finish the analysis of the project to determine whether the firm should proceed with the project or not.

Although not so simple in application the decision process can be simply and succinctly described thus: if the project is worth more than it costs, that is if the cash generated is in excess of all operating and financing cash outlays, than it should be accepted since it will

generate positive profits and hence add value to shareholders. If the project, on the other hand, costs more than it’s worth it should not be accepted.

There are a number of decision tools that managers have available for their use, some 6 of them are discussed in Chapter 13. It should be noted that these are not mutually exclusive and in fact since they all use approximately similar data as input many corporations, but most especially large ones, will press ahead and get information on all or some of these methods. As they all provide different perspectives on the same thing they can lead to differences in nuance and can generate much internal discussion. In rare, but not unheard of, cases these techniques will yield different recommendations.

For each of our decision statistics, we will need to identify how to calculate the decision statistic, then decide on an appropriate benchmark for comparison and finally define what relationship between the statistic and the benchmark will dictate project acceptance. For mutually exclusive projects, we will also have to choose between the competing projects.

In actual practice the Net Present Value – NPV- method is the most widely used and it is the one we will spend the bulk of our time investigating.