Evaluating Capital Budgeting Projects 305
determined by multiplying the depreciable basis by the applicable recovery allowance
percentage. Thus, the depreciation expense for 2003 is 0.20($180,000) $36,000, and
for 2004 it is 0.32($180,000) $57,600. Similarly, the depreciation expense is $34,200
for 2005, $21,600 for 2006, $19,800 for 2007, and $10,800 for 2008. The total depre-
ciation expense over the six-year recovery period is $180,000, which is equal to the de-
preciable basis of the machine.
As noted above, most firms use straight-line depreciation for stockholder report-
ing purposes but MACRS for tax purposes. In this case, for capital budgeting purposes
MACRS should be used. In capital budgeting, we are concerned with cash flows, not re-
ported income. Since MACRS depreciation is used for taxes, this type of depreciation
must be used to determine the taxes that will be assessed against a particular project.
Only if the depreciation method used for tax purposes is also used for capital budget-
ing analysis will we obtain an accurate cash flow estimate.
What do the acronyms ACRS and MACRS stand for?
Briefly describe the tax depreciation system under MACRS.
How does the sale of a depreciable asset affect a firm’s cash flows?
Evaluating Capital Budgeting Projects
Up to now, we have discussed several important aspects of cash flow analysis, but we
have not seen how they affect capital budgeting decisions. Conceptually, capital bud-
geting is straightforward: A potential project creates value for the firm’s shareholders
if and only if the net present value of the incremental cash flows from the project is
positive. In practice, however, estimating these cash flows can be difficult.
Incremental cash flows are affected by whether the project is an expansion project
or replacement project. A new expansion projectis defined as one where the firm
invests in new assets to increase sales. Here the incremental cash flows are simply the
project’s cash inflows and outflows. In effect, the company is comparing what its value
would be with and without the proposed project. By contrast, a replacement project
occurs when the firm replaces an existing asset with a new one. In this case, the
incremental cash flows are the firm’s additionalinflows and outflows that result from
investing in the new project. In a replacement analysis, the company is comparing
its value if it takes on the new project to its value if it continues to use the existing
asset.
Despite these differences, the basic principles for evaluating expansion and re-
placement projects are the same. In each case, the cash flows typically include the
following items:
1.Initial investment outlay.This includes the cost of the fixed assets associated with
the project plus any initial investment in net operating working capital (NOWC),
such as raw materials.
2.Annual project cash flow.The operating cash flow is the net operating profit af-
ter taxes (NOPAT) plus depreciation. Recall (a) that depreciation is added back be-
cause it is a noncash expense and (b) that financing costs (including interest ex-
penses) are not subtracted because they are accounted for when the cash flow is
discounted at the cost of capital. In addition, many projects have levels of NOWC
that change during the project’s life. For example, as sales increase, more NOWC
is required, and as sales fall, less NOWC is needed. The cash flows associated with
For more discussion on re-
placement analysis deci-
sions, refer to the Chapter 8
Web Extension on the
web site, http://ehrhardt.
swcollege.com.Also, the
file Ch 08 Tool Kit.xls,pro-
vides an example of re-
placement analysis.
304 Cash Flow Estimation and Risk Analysis
