Planning Capital Expenditure 293expected life of the new brewery is 10 years. The brewery will be depreciated
to zero over its 10-year life using a straight-line depreciation schedule. Land
for the brewery can be purchased for $1 million. Additional inventory to stock
the new brewery would cost $1 million. The brewery would be fully opera-
tional within a year. If the project is undertaken, increased sales for the beer
company would be $7 million per year. Cost of goods sold for this beer would
be $2 million per year; and selling, administrative, and general expenses associ-
ated with the new brewery would be $1 million per year. Perhaps advertising
would have to increase by $500,000 per year. After 10 years, the land can be
sold for $1 million, or it can be used for another project. After 10 years the sal-
vage value of the plant is expected to be $1.5 million. The increase in accounts
receivable would exactly equal the increase in accounts payable, at $400,000,
so these components of net working capital would offset one another and gen-
erate no net cash f low.
No one expects these forecasts to be perfect. Paraphrasing the famous
words of baseball player Yogi Berra, making predictions is very difficult, espe-
cially when they are about the future! However, when investors choose among
various investments, they too must make predictions. As a financial analyst,
you want the quality of your forecasts to be on a par with the quality of the
forecasts made by investors. Essentially, the job of the financial analyst is to es-
timate how investors will value the project, because the value of the firm will
rise if investors decide that the new project creates wealth and will fall if in-
vestors conclude that the project destroys wealth. If the investors have reason
to believe that sales will be $7 million per year, then that would be the correct
forecast to use in the capital budgeting analysis. Investors have to cope with
uncertainty in their forecasts. Similarly, the financial analyst conducting a cap-
ital budgeting analysis must tolerate the same level of uncertainty.
Note that cash f low projections require an integrated team effort across
the entire firm. Operations and engineering personnel estimate the cost of
building and operating the new plant. The human resources department con-
tributes the labor data. Marketing people tell you what advertising budget is
needed and forecast revenue. The accounting department estimates taxes, ac-
counts payable, and accounts receivable and tabulates the financial data. The
job of the financial analyst is to put the pieces together and recommend that
the project be adopted or abandoned.
Initial Cash Outf low
The initial cash outf low required by the project is the sum of the construction
cost ($8 million), the land cost ($1 million), and the required new inventory
($1 million). Thus, this project requires an investment of$10 million to launch.
If accounts receivable did not equal accounts payable, then the new accounts
receivable would add to the initial cash outf low, and the new accounts payable
would be subtracted. These cash f lows are tabulated in Exhibit 10.1.