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Financial Management - Chapter 10

Capital Budgeting: the process of planning for purchases of long-term assets. Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment? The relevant project information follows: | Chapter 10: Cash Flows and Other Topics in Capital Budgeting 2002, Prentice Hall, Inc. Capital Budgeting: the process of planning for purchases of long-term assets. example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment? The relevant project information follows: The cost of the new machine is $127,000. Installation will cost $20,000. $4,000 in net working capital will be needed at the time of installation. The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. Simplified straight line depreciation is used. Class life is 5 years, and the firm is planning to keep the project for 5 years. Salvage value at the end of year 5 will be $50,000. 14% cost of capital; 34% marginal tax rate. Capital Budgeting Steps 1) Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project. Initial outlay Differential Cash Flows over the life of the project (also referred to as annual cash flows). Terminal Cash Flows Capital Budgeting Steps 1) Evaluate Cash Flows 0 1 2 3 4 5 n 6 . . . Capital Budgeting Steps 1) Evaluate Cash Flows 0 1 2 3 4 5 n 6 . . . Initial outlay Capital Budgeting Steps 1) Evaluate Cash Flows 0 1 2 3 4 5 n 6 . . . Annual Cash Flows Initial outlay Capital Budgeting Steps 1) Evaluate Cash Flows 0 1 2 3 4 5 n 6 . . . Terminal Cash flow Annual Cash Flows Initial outlay 2) Evaluate the risk of the project. We’ll get to this in the next chapter. For now, we’ll assume that the risk of the project is the same as the risk of the overall firm. If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects. Capital Budgeting Steps 3) Accept or Reject the Project. Capital Budgeting Steps Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (Purchase price of the . | Chapter 10: Cash Flows and Other Topics in Capital Budgeting 2002, Prentice Hall, Inc. Capital Budgeting: the process of planning for purchases of long-term assets. example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment? The relevant project information follows: The cost of the new machine is $127,000. Installation will cost $20,000. $4,000 in net working capital will be needed at the time of installation. The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. Simplified straight line depreciation is used. Class life is 5 years, and the firm is planning to keep the project for 5 years. Salvage value at the end of year 5 will be $50,000. 14% cost of capital; 34% marginal tax rate. Capital Budgeting Steps 1) Evaluate Cash Flows Look at all incremental cash flows occurring