The ultimate goal of any financial manager (as well as the firm) is the maximization of shareholders’ wealth. A good financial manager therefore should carefully consider and weigh the risk of undertaking a certain project against the profits associated with undertaking such a project. Capital Budgeting techniques enable the manager to make such decisions.
The first question that comes to mind is, when making a capital investment decision, should we focus on cash flows or accounting profits. The book is stating “In measuring
wealth or value, we will use cash flows, not accounting profits, as our measurement tool. That is, we will be concerned with when the money hits our hand, when we can invest it and start earning interest on it, and when we can give it back to the shareholders in the form of dividends. Remember, it is the cash flows, not profits that are actually received by the firm and can be reinvested. Accounting profits, however, appear when they are
iearned rather than when the money is actually in hand.”
The answer to the question now seems too obvious; it is cash that buys new equipment, used to pay suppliers and employees...etc; it is also cash that is to be reinvested to further increase shareholders’ wealth and hence brings the firm closer to its goal.
This brings us to another question, should all cash flows associated with the project be considered? Again, the book provides an answer “In measuring cash flows, however, the
trick is to think incrementally. In doing so, we will see that only incremental after-tax
iicash flows matter.”
By incremental we mean “marginal”, or “additional”. Incremental cash flows are those
cash flows that would affect the capital budgeting decision, but another condition also applies, those incremental cash flows must be considered on after-tax basis, this is because what really increases the value of the firm is the net cash flow (free cash flow) that would be available to the financial manager in considering future investments. In analyzing a project, one has to also consider depreciation, and although depreciation in itself is a noncash expense, it still affects free cash flow because it has an effect on taxes. Depreciation reduces Earnings before Tax (EBT), and therefore reduces the Tax Expense.
Another important type of cost that needs to be discussed is what is known as “Sunk Costs”.
As discussed above, only incremental (differential cash flows) need to be considered in making a capital budgeting decision, yet if the firm has, for example an empty lot of land that it had purchased in the past and that lot of land is suitable for the investment decision on hand, does the financial manager need to consider the cost of this piece of land when making his capital budgeting decision? The answer is a firm “No”; and the reason behind
this is real logical: if the investment is not accepted, the cost of the land cannot be recovered, hence whether or not the investment is undertaken; the cost of the land (a sunk cost) is irrelevant to the decision.
As I have stated earlier, in making a capital budgeting decision, the financial manager needs to consider only incremental cash flows, and the first of those are the initial outlays.
This is because to take up an investment, the financial manager needs to make sure he has the funds initially required to undertake a certain investment (project). Those include, for example, cost of equipment, installation costs, cost of training as well as any increase in Working Capital.
Based on the above, and based on the calculations on the attached excel sheet, the initial outlay for the new project is $8,100,000.
The second set of cash flows that need to be analyzed is the “Differential Cash Flows”; again as stated above, those are the cash flows that are relevant to the project under consideration. Those include (but are not limited to), added revenues (less added selling expenses), any labor and/or material saved or incurred, any increase or decrease in overhead costs. Needless to say here that all such cash flows should be analyzed on after-tax basis. Such cash flows, however should not include any finance charges whether those are interest charges paid on a bank loan, interest charges on the firm’s issued debt securities, as well as dividends on preferred and common stock. The reason behind such exclusion is that such finance charges are implicitly accounted for when calculating the cost of capital (also known as the Weighted Average Cost of Capital). Having said that, Caledonia’s differential cash flow (as per the attached excel sheet) are:
1 2 3 4 5
$3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000
The last type of cash flows to be examined is the Terminal cash flow which includes all incremental cash flows realized at the termination of the project such as the salvage value of the equipment plus (or minus) any taxable gains or losses associated with selling the equipment. Terminal cash flows also would include any nonexpense cash outlays related
to the project such as the recovery of working capital needs. Caledonia’s terminal cash
flow then is $5,980,000 as per the above table and the attached excel sheet. A cash flow diagram of the project would provide a full image of the cash out flows and cash inflows associated with the project as it would provide a summary of those cash flows that are to be analyzed using the various capital budgeting techniques:
$3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000
0 1 2 3 4 5
i Foundations of Finance. Keown, Martin, & Petty (P.) ii Ibid. (P.280)